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Bonds are not as safe as you think — Pop Economics

Bonds are not as safe as you think

by Pop on May 25, 2010

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Stocks’ less exciting cousins also happen to be less safe than they used to be.

The stock market’s been up and down, sometimes by huge amounts, in the last several months. But one thing’s been consistent: Joe-schmo investors have continued to sink money into bond mutual funds rather than return to stocks. On the week ended May 5th, investors put almost $8.6 billion into bond mutual funds, versus a $1.3 billion withdrawal from stock funds. (The week ended May 12th, they basically withdrew money from all kinds of mutual funds, though stock funds took a much bigger hit than bond funds.)

It’s hard to interpret the motives behind the actions of millions of investors. Indeed, I’m sure they’re going with bond funds for a litany of reasons. But at its heart, I’m sure there’s a general sense that bond funds offer much more safety and stability than stock funds do. They look at bond fund returns over the last ten years and see slight dips, but nothing near the precipitous drops that happened in 2008 and 2009 in stocks.

That idea is reinforced by mainstream personal finance media and allocation advice. Your usual glide-path for a retirement saver will have them moving more and more into bond funds as they age. By the time you’re, say, 60, you’ll have 50% to 60% of your money in bonds.

On its face, the advice is right. Bonds should naturally be safer than stocks. A stock is a part ownership in the equity of a company. You get a share of the earnings left over after all the debt holders, bond owners included, get paid.

But we’re in a less-than-normal environment right now. And I’m afraid that once our ballooning deficit and reviving economy catch up to us, a lot of the bond investors who thought they were “safe” will start to regret their decisions. Here’s why.

How bonds lose money.

I can’t blame people for focusing on the most spectacular way bonds lose money: By defaulting. A company loses money for a while or has a bunch of debt they have to refinance, fails to do so, and then goes bankrupt. The bondholders get in line with every other creditor to try to get their money back. The court process drags on for months, and in the end, depending on how senior your bond was in the debt ladder, you get only a fraction of your principal back.

The threat of default is the reason most of your bond money is probably put in bond mutual funds. Even if a single company kicked the bucket, it would only represent a tiny fraction of your fund’s investments. There’s a deceptive feeling of safety in diversification. If you’re familiar with stocks, it feels like having bonds from hundreds of companies in dozens of industries is enough to protect you from market dips.

But a company default is not the only way a bond loses money. Bonds also lose money when interest rates go up. How does this work? Pretend you bought a bond from Company A for $1,000 that paid $60 (6%) in interest every year. One month later, the rates of comparable Treasury bonds, which have no risk, go up by 1 percentage point. So to invest in your riskier bond from Company A, investors demand to be paid an extra 1 percentage point, too.

Unfortunately, your Company A bond is going to continue paying out $60 per year. So to get that extra 1%, investors will want to pay less than $1,000 for your bond. And voila, your bond has dropped in value.

Diversification doesn’t fix it.

“But,” you might say, “that’s why you buy bonds with different maturity dates!” And it’s true: Bonds with a shorter maturity—that is, that come due in a couple years—will drop in value much less than bonds that come due in a decade-plus.

But despite all that, your total bond portfolio, or your mutual fund’s bond portfolio, has an overall maturity date that’s affected by a rise in interest rates.

It’s rather easy to find it for your bond fund. Take a look at the Vanguard Total Bond Market Index fund on Morningstar. In the “Style Map”, you’ll see that the fund has an average maturity of about 6.6 years. For the measure of how much an interest rate hike would hurt the fund though, take a look at the “duration” measure.

Duration roughly measures a bond’s sensitivity to interest rate fluctuations. If a bond had a duration of 1.5 years and interest rates rose 1 percentage point, you’d expect the bond’s value to fall by about 1.5%.

The Vanguard fund’s duration is 4.5 years. So if interest rates rise one percentage point, we’d expect the fund to lose about 4.5%.

And this is a problem because…

The current yield on a 10-year Treasury bond is about 3.24%. That’s actually a bit below where it has been in the recent past, as investors have fled back to Treasuries with the 10% or so drop in the stock market.

But historically, 3.24% is really low. Some would say, irrationally low. The Federal Reserve, which only indirectly influences Treasury rates, has brought the Federal Funds rate to almost zero. And as part of its efforts to lower bond rates on everything from mortgage-backed securities to commercial loans, it’s undertaken massive bond buying programs which are just now starting to wind down.

In effect, unless we have another stock market crash that brings panicked investors back into Treasury bonds, there’s really no way for rates to go but up. And once Treasury rates go up, as explained in the example of Company A, the rates of every other kind of bond will go up.

Not to take this to the extreme, but what the hell.

In 1984, the average yield of a 10-year Treasury bond was about 12.5%. Admittedly, we had some unique economists making policy decisions, and I’d be surprised if the current Administration would let them get that high. But you can do the math: A nine point rise in interest rates, would nearly halve the value of a bond fund with a 4.5 year duration. (Caveat: Duration is a more accurate measure with small interest rate moves. So with a large move, like the one I’m describing, it’s a bit more unpredictable what bonds end up doing.)

Maybe it’s just me, but I don’t think average investors are computing that risk.

Is there a solution?

Stocks aren’t the answer either. Time periods with high interest rates are generally also pretty crummy times for equities. Investors who really want to keep their money safe have two, viable options: 1. Bond funds with very low durations (i.e. short-term bond funds) or 2. Almost risk-free investments such as CDs, savings accounts, and money market accounts.

There is a third option: to invest in individual bonds and hold them until they mature. But unless you have a lot of money to invest, that gets rid of diversification, which was the reason you were looking at a bond index fund in the first place.

Sadly, I’m guessing most of those regular investors shunting money into bond funds are simply picking index funds or bond funds that are giving high interest rates. So when rates rise, they’ll be surprised by the drop.

Let me back up and say that I don’t advocate that young people (or old people for that matter) move into short-term bond funds and savings accounts. If you’re saving for the long-term, it makes much more sense to invest in risk assets like stocks and longer-term bonds. But if you want to invest safely, I hope this helps you understand what “safe” really is.

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{ 7 comments… read them below or add one }

2 Cents May 25, 2010 at 9:26 am

Good discussion. I think a lot of people aren’t aware of the risks involved in bonds and bond funds in particular. Right now I’m having a hard time figuring out whether the renewed economic worries will keep rates low or whether the bond vigilantes will really start to demand higher rates from borrowers, especially those of the sovereign variety.

Rob Bennett May 25, 2010 at 11:10 am

I agree that the risks of bonds are often understated.

Bonds made sense as a counter to stocks in a world of low inflation. That’s not the world we have been living in from the 1970s forward. My personal take is that bonds are riskier than stocks.

The exception is inflation-protected bonds. I see inflation-protected bonds as a solid choice.

Rob

Edwin | Finantage May 25, 2010 at 6:37 pm

A bond selling at a premium or discount is a form of opportunity cost. Buying a bond at it’s current rate means you are taking the opportunity cost of interest rates increasing in value later. While this is accounted for in the market, opportunity cost of any type is generally not considered by people.

One part I do disagree with you is that interest rates will be going up anytime soon. Rates have been set low to get the economy moving again. They would be increased if either 1) inflation started getting too high or 2) the economy began booming. Nothing indicates either of these actually happening anytime soon.

While the economic outlook is looking up, it is nowhere near a boom where the fed would need to reign in rates. Also, core CPI is slowing down, so there is no indication of inflation on the horizon.

http://www.clevelandfed.org/Research/data/US-Inflation/chartsdata/index.cfm?state1=2&state2=&state3=&state4=&startDate=01/01/2004&endDate=05/25/2010&datatype=2&freq=yearly

Pop May 26, 2010 at 7:17 pm

Hi Edwin, Thanks for your comment. I hesitated to even mention the Federal Funds rate exactly because of the conclusion you just reached. In the end, the Federal Funds rate’s impact on longer term Treasury (and corporate bond) rates is tenuous at best. That’s why 10-year Treasury bond rates have been moving up and down by a few percentage points over the last year even though the Federal Funds rate has been set at almost 0. The point I was trying to make is that Treasury (and therefor other bond) rates have nowhere to go but up.

Personal finance June 7, 2010 at 1:36 am

Very interesting post. Even I thought bonds were safer than stocks. Its not that it has completely changed my mind set but ya will remember your post before investing.

Derek Illchuk October 1, 2010 at 10:59 am

Here’s a less scary way to frame this: if interest rates shoot up, you’re just *missing out* on the nice new rates.

Say you have a $10,000 bond at 2% due in five years, and the latest rates shoot up to 12%. You definitely missed an opportunity, but it’s hard to say your bond was decimated. After all, at purchase you were happy to make the deal, and it continues as agreed.

So, I’m wondering, if a bond fund holds all 2% bonds, how can it’s total value be lost — no matter how high rates go — when it can simply freeze all sales, collect the interest, and ride it out? How can it’s value be cut in half?

Or, if the bond fund sells all within (at a lower value) and invests in these new bonds with the great rates, doesn’t the new high yield make up for everything?

Six of one, half-a-dozen of the other.

Derek Illchuk October 1, 2010 at 11:16 am

Or, I’ll boil it down as follows: if you go into a bond purchase expecting $X at maturity, then — regardless of where rates go or even whether the underlying bonds were held or flipped — you’ll get about $X.

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