Stealing a page from Elliott Management, the $27 billion hedge fund founded by Paul E. Singer, who successfully sued Argentina for payment of defaulted bond issues, other hedge fund managers have been buying distressed Puerto Rican debt hoping for a similar payout.

The strategy works like this:  Puerto Rico is known to be in dire financial straits. With the tax free debt of this US territory trading at large discounts hedge funds have been buying these bonds in the secondary market and hoping to convince congress to bail out Puerto Rico.  Essentially they want the U.S. taxpayers to pay the full price for the bonds they bought for pennies on the dollar.

Fortunately, legislation has just passed out of a house committee that would set up an oversight board to restructure Puerto Rican debt.  Seeing that their gambit is slipping, the hedgies have resorted to buying ads that protest this restructuring and warning that states like Michigan could be the next to restructure their debt and pay less than 100% of bond obligations. These hedge funds conveniently forget that Puerto Rico is not a state.

By remaining quietly in the shadows and using their political contributions to convince your congressional representatives to argue for them, they hope to turn your money into their money by political fiat.

You have heard of the importance of owning a diversified portfolio. For those who do not manage money professionally, the mantra to diversify by investment class is pounded into their heads by the consumer finance media and is rarely questioned.

The reason bonds are included in a balanced portfolio is usually to reduce the overall risk characteristics of a portfolio.  For example, if an investor would be panicked by a short term 20% drop in the value of their holdings as reflected in their monthly statement, then we can add maybe 40% to the bond side, making it likely that a 20% drop in stock prices will only result in a 12% drop for that investors statement (.6 allocation to stocks X .2 short term drop in value). It is not that bonds offer superior returns, it is that bonds sometimes provide better returns than stocks with less volatility.  The same reduction in risk can be achieved by holding cash and money market funds, but historically bonds have outperformed cash.

Yet when markets enter periods of extreme turmoil like 2008 and 2009 the usual correlations of investment returns fly out the window and bonds can tank at the same time stocks tank. And when interest rates rise bond prices will fall.

So my question to you is: Why do you own bonds?  Are you afraid of the temporary drops in stock prices or are you just following the mantra of the popular press?  With interest rates poised to rise would you be better off using cash as a buffer?

You have heard of the importance of owning a diversified portfolio. For those who do not manage money professionally, the mantra to diversify by investment class is pounded into their heads by the consumer finance media and is rarely questioned.

The reason bonds are included in a balanced portfolio is usually to reduce the overall risk characteristics of a portfolio.  For example, if an investor would be panicked by a short term 20% drop in the value of their holdings as reflected in their monthly statement, then we can add maybe 40% to the bond side making it likely that a 20% drop in stock prices will only result in a 12% drop for that investors statement (.6 allocation to stocks X .2 short term drop in value). It is not that bonds offer superior returns; it is that bond returns are usually not correlated with stocks and fixed income returns are usually less volatile than stock returns.  The same reduction in risk can be achieved by holding cash and money market funds, but historically bonds have outperformed cash.

Yet when markets enter periods of extreme turmoil like 2008 and 2009 the usual correlations of investment returns fly out the windows and bonds can tank at the same time stocks tank. Another risk to owning bonds is the inverse relationship of bond prices to interest rates; if interest rates rise bond prices will fall.
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So my question to you is: Why do you own bonds.  Are you afraid of the temporary drops in stock prices or are you just following the mantra of the popular press?  With interest rates poised to rise would you be better off using cash as a buffer? 

Duration has a special meaning in the investment world.  It is a measure of interest rate sensitivity in bond portfolios.  You can calculate the duration for an individual bond or for a portfolio of individual bonds and you can derive an average duration.  Why is this important?  Because in a rising rate environment, like the one we are just entering, the duration will give you an idea of how much your principle will decline for a given increase in interest rates.

If your bond portfolio or your bond fund has an average duration of 6 years then you can expect the value of the portfolio to drop by about 6% for every 1% increase in interest rates. The Pimco Total Return Bond Fund with assets of around $246 billion dollars is one of the largest bond mutual funds in the United States. With an average duration of 5.26 years you could expect about a 5% drop in the funds value if interest rates rose by 1 percentage point. Or you could expect a 1.25% drop in value if interest rates rose by just 0.25%.
Given that most bond funds have a yield of around 3% you can see that even small changes in interest rates can wipe out months of dividend income. So you should be aware of the duration of any bonds or bond mutual funds you own.
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Then ask yourself if the risk is worth the reward at this point