A Simple Relationship to Put Money in Your Pocket

Every US based worker that has attended a 401K planning seminar has heard the same lecture.  Diversify your money between US based Large, Mid and Small Cap stocks then mix in some International Stocks and Bonds.  Your percent allocation to each sector will vary depending on your age.  It must be sound advice if some many professionals agree on this approach.  Most will follow this advice tweaking it every now and then.  However, with a little more understanding you can outperform those advisors.

The objective of investing is to buy low and sell high which is not as easy as it sounds.  Well at least in the stock part of your portfolio.  However, it is slightly easier to do with your bond allocation.  The key to bonds is interest rates.  As interest rates go up, bond prices go down.  As interest rates go down, bond prices go up.  That is all the average investor needs to know about bonds. 

Let’s say that you purchased a bond that was paying 3% interest and then interest rates increase to 3.5%.  Why would a new investor buy your bond paying 3% – when a new one could be purchased that returned 3.5%?  Thus, the only way to entice people to buy the 3% bond is to lower its price (rates goes up price goes down).  Now the investor has a choice of buying the lower yielding bond at a lower price versus the new higher yielding bond at a higher price.

The Fidelity US Bond Fund (FBIDX) is available in many 401K plans.  Its returns over the last 6 ½ years is as follows:

 

  2000 2001 2002 2003 2004 2005 YTD 5/2006
Total Return% 11.4 8.1 10.2 4.9 4.4 2.3 -0.8

 

What happened to the returns?  Interest rates were low in the first years of the decade; then the fed went on rate raising campaign that commenced in June of 2004. By knowing the relationship between bonds and interest rates, a savvy investor would act accordingly.  Thus, bond allocations would increase in low interest rate environments and decrease in high interest rate environments.  I bet you didn’t hear that in your 401K seminar. 

Just a little financial education will carry you a long way and lead to better results. As we are nearing the end of the interest rate increases here is Bill Gross’, often referred to as “the Warren Buffett of the bond world,” current position.

July 7 (Bloomberg) — Bill Gross, chief investment officer at Pacific Investment Management Co. and manager of the world’s biggest bond fund, said the bear market in bonds is over.

“The bond bear market is beginning to go into hibernation, which is the same thing as saying the bear market’s over,” said Gross in a television interview from the firm’s headquarters in Newport Beach, California. “It ended two days ago on Wednesday. While we’re not about to reap huge capital gains, bonds will do better from here in terms of price.”

As rates go down bond prices go up.

 

Update 9/23/06: 

On August 8, the Fed after 17 consecutive rate hikes decided to pause and hold the federal funds rate at 5 1/4.  Also, no policy action was taken at the Fed meeting on September 20.  This environment has led to a nice run up in bond prices.  The yield on the 10 year Treasury note is 4.6% its lowest level since March and the price as represented by the FBIDX is 2.34% YTD.  That is a 3% increase in four months.  It looks like Bill Gross is off to a good start.

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