Guzzo the Contrarian

The Vanguard Group has posted a interesting article in their Insights section on something of concern to bond market investors – the inverse relationship between bond prices and interest rates.

As excerpted from Bonds and rates: The reality behind the headlines:

Moves in interest rates are notoriously hard to predict, but that hasn’t stopped many market observers from declaring that rates are headed up in the near future. If the predictions are right and rates do climb, you’re sure to see headlines about how such an environment is bad for bond investors.

As is so often the case, the headlines won’t tell the whole story. It’s true that a general rise in rates will cause bond prices to fall and thus reduce the returns of most bond funds in the short term. But the higher rates can boost returns for long-term bond investors who stay disciplined about reinvesting their interest income. The reality is that if you’re steadily reinvesting your interest income, rising interest rates can be good news.

While this inverse relationship between interest rates and bond prices is important, Vanguard goes on to discuss how it’s interest income, and re-invested income, which matters most in bond fund; and that it’s in investors’ best interests to remain invested in a bond fund for the long term instead of trying to time the market.

Of course, one could argue that Vanguard is discussing this topic only because it’s in their own best interests to reduce turnover, as fund turnover increases fund costs. But, I believe that Vanguard is also looking out for their investors, and what they say makes good sense.

There’s also another strategy one could use to successfully invest in bonds, without being too concerned about where interest rates are headed.

Figured it out yet? That’s right, investing in I-bonds. I’ve previously written about I-bonds on a few occasions, and it’s the only type of individual bond in which I invest.

For those who aren’t aware of them yet, like other savings bonds issued by the United States Treasury Department, I-bonds are a low-risk, liquid savings product that earn tax-deferred interest and protect you from inflation. The I-bond earnings rate is a combination of two separate rates; a fixed rate and an inflation rate, both which are determined twice yearly in May and November.

Currently, I-bonds are one the safest and highest-yielding bonds available to most individual investors. So, if inflation rates do happen to rise, it wouldn’t be unreasonable to expect I-bonds to yield even higher rates. There are also other intangible benefits of investing in I-bonds, but don’t just take my word for it. See what The Duke has to say.