The stock market keeps jumping to record highs, prompting many to worry about a long-overdue correction or even a bear market. The logical move when stocks are at record highs is to look for cheaper alternatives, with an aim toward rebalancing and diversifying your portfolio to gain suitable exposure to various asset classes.
When multiple markets have done well, however, you can't afford to merely follow a playbook without thinking more carefully about it. In particular, the current financial-market environment makes what many consider to be the safest investment in the market much riskier than usual -- and those who started 2018 by switching some of their stock exposure into this perceived "safer" asset class have been surprised at the losses they've suffered. It's still not wrong to rebalance your portfolio, but you have to think twice about exactly what assets you ought to purchase to make up for a lower stock allocation.
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Years of soaring stocks, soaring bonds
The recovery from the financial crisis since 2009 has been extraordinary not just in the extent to which stock markets have rebounded but also because other financial markets have seen impressive returns. Since the early-2009 lows, the S&P 500 (SNPINDEX: ^GSPC) has produced average annual returns of very close to 20% with surprisingly little volatility along the way. Under such conditions, you might expect to have seen bonds perform poorly.
Yet while their returns haven't stood up to stocks' gains, long-term Treasury bonds have still performed well, especially in light of extremely low yields. Since early 2009, the iShares 20+ Year Treasury Bond ETF (NYSEMKT: TLT), which tracks long-term U.S. Treasury bonds, has returned an average of about 5.5% annually, including both interest income and capital appreciation.
The fact that stocks have gone up more than bonds would generally lead investors to sell off some of their stock holdings in order to reinvest the proceeds into bonds. Such a move would be prompted by an assumption that, after a long period of outperformance, stocks would be more likely to underperform bonds -- especially in the event of a reversal of the bull market that both of these asset classes have seen since 2009.
Yes, Treasury bonds can lose money
Many investors mistakenly believe that Treasury bond investments are safe from loss of capital because they're backed by the full faith and credit of the U.S. government. It's true that if you buy a Treasury bond at face value, you're guaranteed to collect interest along the way and get your principal back if you hold the bond until maturity. But with many investments in Treasuries that don't typically involve holding securities to maturity, you can lose money.
Already in 2018, many investors have found that fact out the hard way. In just three weeks, the iShares 20+ Year Treasury ETF has already lost 2.5% of its value. Even the less aggressive iShares 7-10 Year Treasury Bond ETF (NYSEMKT: IEF), which invests in short-term bonds that tend to be less volatile in price than their longer-term counterparts, is down 1.5% since Jan. 1.
The reason: Yields have been on the rise, driving bond prices down. Since the beginning of the year, the yield on the 30-year Treasury has climbed from around 2.75% to 2.9%. The yield on the 10-year Treasury has risen from 2.4% to 2.65%.
The scary thing for long-term investors is that those movements aren't all that large, yet they've already resulted in total-return losses so far in 2018. As recently as 2011, 30-year Treasury yields were at 4.75%. A rise back to those levels could produce double-digit-percentage losses for those holding long-term bonds.
The more prudent way to reduce your risk
Fortunately, most investors have a simple alternative to bonds and bond funds: bank CDs. Most small investors can buy CDs at rates that are more favorable than those of Treasury bonds of the same maturity. Besides, CDs carry the same level of government protection, as long as you follow the FDIC limits at each banking institution.
Even better, bank CDs don't have the interest rate risk that bonds have. If you need your money before maturity, you can usually get access to it by paying a penalty, typically between three months' and one year's worth of interest payments. That's obviously something you want to avoid, but it'd cost a lot less than potential double-digit-percentage declines that bond funds could suffer.
Rebalancing to reduce concentrated stock risk after the market's massive gains is smart. But don't just buy the same old bond investments you've used until now. Although these perceived safe investments have had solid returns in light of past conditions, most bonds have considerable rate-related risk right now, which could cause unexpected losses.
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