The year 2018 has been volatile for the markets. Stocks rapidly climbed to record territory early in the year before finally posting a long-awaited correction. And the energy market has seen a dramatic rise in oil prices that's helped to bolster prospects for oil and natural gas related companies. Yet for conservative investors, one popular investment that most see as being particularly safe has turned out to be a big loser, and that's forcing many people -- especially retirees -- to reconsider how they invest more broadly.
Retirees and those approaching the end of their careers often are advised to reduce stock market exposure. Instead, many end up putting larger percentages of their savings into fixed-income investments like Treasury bonds. Although Treasuries are backed by the full faith and credit of the U.S. government, making them the safest dollar-denominated debt instruments on the planet, they are far from risk-free. As many retirees are learning the hard way in 2018, Treasury bonds can lose money, and current trends suggest that those tough times could continue.
Image source: Getty Images.
End of an era?
The bull market in stocks over the past decade has been remarkable, taking major market benchmarks from rock-bottom lows to a long succession of record highs in a very short time span. But what's been even more remarkable is that the bond market has largely seen prices move in the same direction as the stock market over much of that period.
That's not unprecedented, but it doesn't happen as often as you might think. Typically, what helps the stock market rise is the expectation that the economy will grow stronger, spurring more business activity. When businesses have greater opportunities to grow, they tend to raise more capital, boosting demand for investment and thereby pulling interest rates higher. The resulting rise in rates makes existing lower-rate bonds less valuable, and so the bond market often moves in the opposite direction as the stock market. Similarly, when stocks fall, many investors start to look to bonds as an alternative, and economic slowdowns can create less demand for financing that in turn helps to reduce prevailing interest rates.
Until this year, bonds had done a good job of holding their own even under increasingly difficult conditions. However, the most recent discussion of interest rate increases from the Federal Reserve has finally started to show up in some of the longer-term Treasuries that are favorites among many investors, and that's created some big shocks in terms of the extent of losses that the fixed-income market has suffered so far in 2018.
Where the bond losses are
In general, the longer a bond has until maturity, the more sensitive it is to interest rate movements. That has generally held true for Treasuries in 2018. The iShares 20+ Year Treasury Bond ETF (NYSEMKT: TLT), which holds Treasury bonds with the longest maturities available, has seen its price fall 8% so far this year. Even when you take into account the income that bond ETFs provide, the iShares fund's total return is still -7%.
Shorter-duration bonds haven't produced losses that are quite that bad, but they've still seen uncharacteristically large declines. The iShares 7-10 Year Treasury Bond ETF (NYSEMKT: IEF), which focuses on intermediate-term Treasury debt, has fallen 4% since the beginning of 2018 even after taking income into account.
Finally, some closed-end funds provided investment opportunities in bonds, and those funds have seen some of the largest declines. Losses of 10% or more haven't been uncommon in some areas of the closed-end bond fund market, especially those funds that utilize leverage to amplify their returns.
Be smart with your bond exposure
There are two things that conservative investors should understand right now. First, because of the rate risk associated with long-term bonds, you might be better off sticking with short-term fixed-income investments. Bank CDs don't have the same level of rate risk, because you can typically cash them in for a modest penalty and reinvest at higher rates if necessary. Even money market bank accounts have interest rates that approach what short-term Treasuries pay, and as the difference in rates between short-term and long-term bonds narrows, you're not getting as much extra reward for taking on rate risk.
Second, many investors become overly conservative too quickly as they approach and enter retirement. Rather than investing solely in bonds, many retirees need to stick to the stock market with a substantial portion of their investments in order to ensure they can get the growth they require to help them meet their needs throughout their retired years.
Treasury bonds are generally seen as safe, and they do provide protection against default that other types of bonds lack. Yet even Treasuries can fall when rates rise, and with future moves likely to continue the trend toward higher rates, retirees and other conservative investors need to think carefully about their overall strategy toward asset allocation -- and potentially replace long-term Treasury bonds with different investments.
More From The Motley Fool