Should You Be Worried About a Crash in Bond Prices?

Friday’s jobs report from the U.S. Labor Department revealed an unexpected surge in U.S. job gains in May. As a result, bond investors are getting nervous, with some headed for the exits and dumping shares on a bet that the Federal Reserve will raise the federal funds rate in September.

bill-gross-bond-fundBut should investors worry about a crash in bond prices? Are the negative financial media reports just a bunch of noise, or is there really something to worry about for bond investors?

Bond prices generally move in the opposite direction as interest rates, and the Fed has made it clear to markets that a rate hike could come later in 2015. Even ahead of the jobs report, a big selloff in bonds sent the major bond indices, including the Barclays Aggregate Bond Index, into negative territory for the year.

But the Fed has also communicated that any rate hike is contingent upon a healthy economy. Although the U.S. economy appears to be moderating, a strong U.S. dollar is hurting corporate profits, especially among the big multinational corporations crucial to macro-economic health.

On Thursday, the International Monetary Fund iterated its concern over a strong dollar and urged the Federal Reserve to hold off on interest rates hikes until 2016. But Fed Chairwoman Janet Yellen still has not changed her stance made public last month, when she said that she expects a rate hike by the end of 2015.

Why a Rate Hike May Not Come Until 2016

Although the Fed has hinged interest rate increases on healthy jobs and wages, there is still the concern over the strong dollar and one other factor, which is at the core of why the Fed tightens monetary policy: inflation.

Historically the Federal Reserve has used monetary policy to keep a lid on inflation. But if inflation is not getting too hot, and there are no significant factors present that could push inflation higher in the short term, the need for a rate hike is diminished.

In the Fed’s most recent policy statement it put a 2% target on inflation. But thanks to plummeting oil prices, U.S. consumer prices fell 0.2% in April year-over-year. Excluding volatile food and energy prices, core inflation grew just 1.8% over the 12-month period.

The Outlook and Healthy Perspective for Bond Investors Now

Barring any negative surprises, there won’t be a crash in bond prices any time soon. A 2015 increase in interest rates is mostly priced into bond prices now – especially after the recent selloff.

Also, the volatility in the markets lately is most pronounced in global bonds and high-yield bonds, which will remain on the front of the bond price battle as fixed-income investors look for the first signs of an exit.

For example, as of mid-day Friday, the year-to-date return on high-yield global bonds, as measured by the iShares Global ex USD High Yield Corporate Bond ETF (NYSEArca: HYXU), is negative 4.9%. By comparison, the average U.S. bond with higher credit quality, as measured by the iShares Core U.S. Aggregate Bond ETF (NYSEArca: AGG), is only down about negative 0.4% thus far in 2015.

As I wrote two weeks ago, now is not the best time to hold high-yield bond funds. But a diversified bond mutual fund or exchange-traded fund, like the AGG fund or a similar index fund, can be a good idea – especially for long-term investors in this volatile period.

With that said, the short-term noise and brief panic on the part of some investors is also likely to continue the volatility and keep downward pressure on bond prices in the near term.

The bottom line for bond investors is to stay diversified, expect a mild correction in the short term, and keep your eyes on the long term while you enjoy your summer.

As of this writing, Kent Thune did not personally hold a position in any of the aforementioned securities. However, he holds AGG in some of his client accounts. Under no circumstances does this information represent a recommendation to buy or sell securities.

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