4 Potential Outcomes You Might Face If Bond Yield Plunges Down
There’s a lot of talk about bonds being in the midst of a bubble, but that goes against clear evidence in the market. Bond yield continues to drop – that doesn’t occur in a bubble.
As Min Zeng and Christopher Whittall noted, US government bonds have hit historic lows after Brexit and the continued loosening of central bank policies.
In fact, there’s really no sign of the bond yield improving – it will continue to drop.
Personal Actions with a Plunging Bond Yield
One of the first things you’ll see as bond yields continue to drop is a change in personal actions. Many people will start saving their money, keeping it out of the market and stored against potential future financial disaster. It becomes their safety blanket.
Others will spend less in retirement, reducing their quality of life and their comfort level in exchange for a little extra cash in the bank. Yet others will be primed to take on more risk in an effort to bolster flagging earnings. Finally, there’s the possibility that some people will do all three of these things.
Trouble with Pension Funds
You can definitely expect to see trouble with pension funds. Most will experience serious hurdles with their funding status due to the worsening mismatch between assets and liabilities.
Many pensioners will see benefits being cut, although many municipalities will make larger contributions to help secure pension funds. Public officials can expect both of these realities to wreak havoc with their campaigns and face significant trouble at the polls. Look for “dark horse” candidates to become much more viable.
Insurance Company Struggles
Insurance companies have historically invested a great deal of their money into bonds, and if the bond yield continues to plunge, you can expect to see those companies struggle.
This could lead to any number of ramifications, including rate hikes for customers, reduced coverage, and other problems.
While it might be hard to feel much sympathy for these companies, understand that the investments are used to generate returns for investors of the company, so real people are being hurt.
Unhappiness for Fixed Income Investors
Ultimately, a lower bond yield is going to result in some very unhappy fixed income investors.
This is particularly true for those who put their money into high-duration securities. As the yield drops, these investors will have to tighten their belts more and more, and there is only so far that this will take you.
With all this being said, plunging bond yield is at least somewhat balanced by continued historic lows in mortgage interest rates and other lending areas. As long as those rates remain low, the bond yield reduction is balanced to some extent and losses can be mitigated.
Laddering to Protect Against Plunging Bond Yield
So, what are investors to do if the bond yield continues to plunge? How do you protect yourself in this environment?
There are options, and one of those is bond laddering. You can earn a steady corporate bonds yield instead of buying stocks from the top. So, what is bond laddering and why does it matter? What sort of protection might this offer your financial future?
Bond laddering is really nothing more than strategically investing in bonds with different due dates.
For instance, let’s say you had $200,000 to invest. You’d put $20,000 of that into 10 different bonds, each of which would come due across a 10-year span, with one bond coming due each year.
That provides you with a ladder to climb into the future. Or, if it helps, think of it like stepping stones. Each bond is one more stone in your path to success. In fact, bond laddering can help protect your wealth from the rising interest rates and plunging yields of bonds.
Of course, creating your bond ladder requires the application of strategy. You’ll need to plan for the future, and take a long, hard look at years where you may need additional funds.
For example, suppose your child will be graduating high school and starting college at some point. That is a date that can be planned for, and you can buy bonds that will come due at the time they enroll in school, and then in subsequent years to help offset the costs of tuition.
Another example would be if you plan to buy a new home in the next few years – purchase bonds that will come due about the time you plan to purchase that new home.
After you’ve planned for your foreseeable financial needs, you’ll need to consider the yield curve. This is nothing more than a chart that illustrates the interest rates that bonds of the same credit quality pay, but with different maturity parameters.
By creating such a ladder, you can protect yourself against rising interest rates and plunging bond prices. However, you’ll need to realize that every passing year shortens your ladder by a rung (or removes a stone from your path if you prefer that analogy).
By putting this tool in place as quickly as possible, you can begin to take advantage of market movements. With that being said, be aware that long-term bonds may not be the best option, particularly with lowering bond yields.
Remember that ultra-high duration bond holders are likely to suffer, at least in the short term, so make smart, informed moves that will protect your lifestyle.
The silver lining to all of this is that the Fed will be raising interest rates very soon as we shake off the last lingering effects of the Great Recession and fight to overcome the ripples spreading by the UK’s vote to leave the EU. When those rates go up, bond yields will also go up, providing you with better earning potential and safeguarding your wealth.