by John K. McGill, JD, CPA, MBA, and Jeff Harrell, CFA
It seems doctors can't turn on the TV or read a financial newspaper without stumbling on someone telling them to sell their bonds. Interest rates are on the verge of skyrocketing, and doctors stand to lose a lot of money in bonds, or so the theory goes. If you're reading this article looking for another excuse to ditch these seemingly worthless investments, you should turn the page now. Unfortunately, this popular recommendation fails to explain the complexity of an extremely important and diverse asset class.
Before discussing the prospects for bonds, it is crucial to understand why doctors own them. For the majority of doctors, bonds serve as a vital component of a well-diversified portfolio. Bonds tend to experience less volatility than stocks and have traditionally served as ballasts to a portfolio when the inevitable financial storms arise. According to research firm Ibbotson, since 1926 there has never been a 10-year period in which a portfolio with 50% stocks and 50% bonds lost money. This statement cannot be said for portfolios with more than 75% of their assets in stocks. Since most doctors tend to be apprehensive to portfolio losses, we think all doctors should have a small portion of their portfolio allocated to bonds.
With interest rates at record low levels, conventional wisdom suggests that rates have nowhere to go but up. While this seems plausible, just because the majority of people expect an event to happen doesn't mean it will. Since the stock market bottomed out in 2009, economists have forecast that interest rates will rise for four consecutive years, and they have been proven wrong every time. If you think this trend can't persist, take a look at Japan. Their 10 Year Treasury dropped below 2% in 1997 and currently resides below 1%. This reduction in yields occurred after the bursting of a real estate bubble, followed by an easy monetary policy, which resulted in an explosion of government debt. Sound familiar?
Additionally, many doctors have the fundamental misconception that all bonds have the same amount of interest rate sensitivity. In reality, bond prices are a function of two variables — interest rates and credit quality. Bonds with stronger fundamentals and lower yields tend to have more interest rate sensitivity, while lower quality bonds with higher yields experience price changes that are more a function of credit spreads. Credit spreads measure the difference in yield between two segments of the bond market such as high yield vs. U.S. Treasuries. Investors demand higher yields for less creditworthy borrowers. When economic conditions improve, this spread typically tightens. When economic conditions weaken, spreads widen. Since most economists who predict higher interest rates are also forecasting an improvement in the economy, bonds with less interest rate risk and more credit risk should perform better. As a result, doctors should review their portfolios to make sure their bonds are well diversified across all credit qualities.
After assessing credit quality, doctors should review the average maturity of their bond investments. In general, the longer the maturity, the greater the interest rate risk. If doctors are investing in bond funds, an excellent way to check on the interest rate sensitivity is to look up the duration. This is a measure of the potential loss a doctor can expect if interest rates rise 1%.
One example is that a fund with a duration of four years can expect to lose 4% if interest rates rise 1% over the course of a year. If the fund has a yield of 3%, the total loss would be roughly 1%. If doctors are worried about an imminent rise in interest rates, they need to consider reducing exposure to funds with durations greater than five years.
Finally, before jumping on the higher interest rate bandwagon and abandoning bonds, doctors need to be sure they understand the ramifications of this forecast. Rising interest rates would lead to an increase in borrowing costs and higher mortgage rates. With bank lending still constrained and the real estate market just beginning to recover, a sharp rise in interest rates would hurt small businesses and the housing market. Higher taxes, subdued employment growth, and rising energy prices are already slowing the economy. Rising interest rates would only exacerbate the problem, so don't be surprised if interest rates remain low and confound the experts for a little while longer.
John McGill provides tax and business planning services exclusively for the dental profession, and publishes The McGill Advisory newsletter through John K. McGill & Company, Inc., a member of The McGill & Hill Group, LLC. Jeff Harrell provides investment advice through Select Consulting, Inc., A Registered Investment Advisor and affiliate of The McGill & Hill Group, a one-stop resource for tax and business planning, practice transition, legal, retirement plan administration, CPA, and investment management services. For more information visit www.mcgillhillgroup.com.
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