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Stocks are up... are bonds going down?

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Stocks heading up – Bonds down?

The 10-year Treasury note has lost nearly ten percent of its value, the largest six-week drop since 1980 according to Barron’s. In July, bond funds suffered their worst monthly loss in 16 years, according to Lipper. This has been a market move that hasn’t been seen for many years. The cause was a rise in interest rates. This could be a good sign as a whole. It hints of a renewed confidence in corporate profits and possibly some moderate price increases. 

During the spring and early summer, interest rates moved to 40-year lows as investors became comfortable with the prospect of a Federal Reserve that would consider unconventional means (such as the repurchase of longer term debt) to re-ignite the economy. 

However, the Federal Open Market Committee’s rate reduction of only 25 basis points and Federal Reserve Chairman Greenspan’s testimony to Congress that the possibility of unconventional policy being used is remote, have pushed bond prices dramatically lower. Although Greenspan has strongly hinted the Fed would maintain an accommodative monetary policy until the economy was operating at full potential, and many bond traders believe that to mean the Fed won’t raise rates until 2003-2005, the capital markets have begun to march to their own drummer in the face of strengthening economic data. 

The price erosion in the fixed income arena has been mainly due to the rise in the general level of interest rates, not due to any systemic credit deterioration across the board. As interest rates rise, bond prices fall. 

The events in July further illustrate the need for a diversified portfolio. Those investors who have stocks, bonds and cash as a portion of a balanced portfolio should have weathered this downturn in the bond market reasonably well. They also provide a great argument for laddering maturities, which enables the investor to weather the cyclical nature of interest rates. Laddering gives the ability to recoup principle and re-invest at varying points along the cycle. 

 There is still the possibility of negative results in the high quality fixed income sector. Shortening the duration of your fixed income component should help protect your principal. There are bonds that have a step-up coupon, or variable rate component, which will offer some protection in a rising interest rate environment. Federal Home Loan Bank offers bonds in varying maturities with a step-up coupon provision. These bonds are free from state income tax and are AAA rated issues. 

This event also reminds us of the importance of a strict investment discipline, which I believe should include asset allocation, diversification and rebalancing your portfolio. As bond prices increased they would have accounted for a greater percentage of a total portfolio. Re-balancing would have caused the investor to sell some bonds and purchase other asset classes within the portfolio. Also, re-visiting the asset allocation during different economic cycles can provide guidance. 

It could be time to consider increasing the weighting in stocks or equity mutual funds, making sure you are well positioned for a turnaround. Investors in the equity markets have finally begun to smile over the past few months. Remember the change in the tax laws: capital gains and dividend income are treated more favorably. It might be a wise strategy to hold fixed income in your retirement account and equities outside of your retirement holdings. Investors need to be watchful of congressional action or inaction since the tax reductions on investment income will revert back to their 2002 rates in 2009 unless Congress takes further action. As always, you should consult with your tax advisor for specific advice.

Nancy Hadley is an investment representative with DA Davidson in downtown Sandpoint.







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Nancy Hadley

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investing, Market Outlook, bonds

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