Bonds prove that common wisdom can be wrong

Earlier this year a rash of news stories and market commentaries warned investors about a coming decline in the bond market. The Federal Reserve had all but guaranteed it would begin raising interest rates for the first time in four years in order to head off incipient inflation.

Rising rates are bad for bonds: their prices fall. The general wisdom in early spring was that bonds were becoming dangerous and that investors who had enjoyed a three-year ride on falling rates had better sell off their bonds or reduce their average maturities in order to weather the coming rate shocks.

The Fed, true to form, followed through in June and approved an interest rate increase, following up with a second increase in August. So where is the bond market? The index of 10-year Treasury Notes was up by 3.5% in late August. Corporate bonds were up by 2.7% and mortgage backed securities by 2.8%. Meanwhile, stocks were down by anywhere from 2% to 9% depending on the index. This disparity illustrates the dangers of following popular wisdom. When you hear everyone predicting the direction of an investment market it is often best to run the other way.

In any event, forecasting short-term returns of different markets is virtually impossible. It is better to ignore the predictions and maintain a balanced portfolio that commits a portion of your money to each asset class. Bonds are an important diversifier in any portfolio. They cushion your portfolio during market shocks, such as a terrorist attack or a market crash. During periods of rising rates they fall in value for a while but as you reinvest at higher interest rates you will obtain higher returns with less volatility than in stocks.