Bonds May Not Be as Safe as You Think: A Cautionary Tale
Business + Economy

Bonds May Not Be as Safe as You Think: A Cautionary Tale

A tsunami of investment dollars has flowed from stocks, and more recently money market funds, into bonds. The flood began in 2007, as investors sought shelter from imploding stock and real estate prices and picked up steam in 2008 and 2009, as historically low interest rates on CDs, money-market and bank accounts sent investors searching for higher yields. While the S&P 500 is down 4.5 percent this year, Barclays Capital Aggregate Bond index gained 5.2 percent, and Treasury bonds maturing in 20 years or more rose 17.9 percent. Call it the bond bubble — this season’s equivalent of the frenzy.

But if investors think their money is safe in bonds and bond funds, they need to think again. “Bonds are not a risk-free investment,” warns Mark Phelps, CEO of money manager W.P. Stewart & Co. “If you go back to previous periods like 2003 or 1994, you could lose a lot of money in bonds.” Echoes veteran financial planner Harold Evensky: “This is classic behavior. Investors are running to what they think is safe, and running away from stocks. They may end up jumping from the frying pan into the fire.”

At this stage of economic and market cycles, individual investors would be expected to begin shifting money back from bonds to stocks as their tolerance for risk increases. Indeed, that was happening at the beginning of this year. But after the “flash crash” in May sent the Dow Jones Industrial Average down a breathtaking 600 points in five minutes, and the recovery started to slow, the flight from U.S. stocks to bonds resumed. After rising slightly in March and April, money flows into U.S. stock funds dropped by $19 billion in May, while bond fund flows increased $14.5 billion. From January through July, domestic stock flows dropped an estimated $33.1 billion, while bond funds increased by $185.3 billion.

It’s true that stocks are generally more risky than bonds. Buying a stock is buying a share in the company’s future earning potential. If earnings grow, stock prices are likely to rise, and investors are likely to benefit when they sell. In the meantime, you may also earn dividends. But if the company disappoints, the price can drop like a rock. As some dot-com investors learned the hard way, you can lose everything with stocks. With a bond, you are lending money to a company, country or state in exchange for an IOU guaranteeing that the issuer will return the principal at some future date, and generally pay regular interest payments until the bond matures. Even in bankruptcies, bondholders have precedence over stockholders.

But bonds are by no means as safe as, say, FDIC-insured bank accounts or certificates of deposit. If a bank goes under, deposits up to $250,000 (per depositor, per bank, for each category of account) are insured by the federal government. Not so with bonds, although they do offer higher yields.

Different faces of bond risk
Bonds’ risks come in different shapes and sizes. There’s default risk, that the borrower may fail to make interest payments or repay principal in a timely manner. Treasury bonds, which are backed by the full faith and credit of the U.S. government, are generally considered not to be at risk of default. Not so, however, for countries like Greece, where default fears sent the prices of sovereign debt across much of Europe collapsing.

Then there is what’s known as credit risk, that a country or company’s credit rating will be downgraded and prices will plummet. Think GM bonds, which imploded in 2005 after being downgraded to junk status. There is also liquidity risk, which played out in late 2008 when credit markets seized up as a result of forced and panic selling in the wake of the subprime lending crisis. Suddenly, banks were unwilling to buy short-term paper from companies that used it to finance operations. Money market funds, usually considered ultra-safe, invest in these instruments, and when their values plummeted, the net asset values of some funds dropped below the target of $1 a share. Many more were on the verge.

Despite the slowing recovery, some risks seem to have receded. As the economy has moved from recession to recovery, corporations are flush with cash. And despite huge federal deficits, there continues to be demand for Treasury bonds from foreign countries looking to recycle dollars earned on their U.S. exports, and from shell-shocked investors in search of an alternative to stocks and low-yielding bank accounts. Even cash-strapped states like California seem to be willing and mostly able to pay their bondholders.

But there’s another risk that bond investors may be underestimating: interest rate risk. It’s true that with a slowing economy, the Fed has no intention of raising interest rates anytime soon. Quite to the contrary, the central bank has committed to holding short-term rates low for as long as it takes to get the economy rolling again, while helping to hold down longer-term rates with its purchases of Treasurys in the open market. But sooner or later, when the economy gets cranking again, interest rates will rise. And when they do, bond prices will fall as investors seek higher-yielding new issues. Depending on the kind of bond or bond fund, investors could lose a lot.

For example, let’s say you own an intermediate-term bond fund. If rates go up 2 percentage points, you could lose nearly 9 percent on your investment. If you own a fund stuffed with longer-term Treasurys, a two-point rate hike could shrink your portfolio by 40 percent. Ouch.

What you can do
Of course, no one know when interest rates will rise, or by how much. But at some point in the next few years – assuming we are not headed into another Great Depression or Japanese-style lost decade, they will rise, and bond prices will fall. In a well-managed fund, or if you hold bonds with a variety of maturities, some of that loss can be made up by replacing maturing bonds with higher-yielding ones. But you’ll still lose money, just not as much.

There are alternatives, albeit with lower yields. For an emergency fund, for example, it’s best to stick with an FDIC-insured bank account. For specific near-term goals, like paying a college bill, consider a short-term CD or Treasury with a maturity that coordinates with when you need the money.

For those who are retired and looking for income-generating investments, today’s low-yielding environment is challenging, to say the least. Don’t get locked into long-term bonds in an effort to grab a higher yield. Consider a bond ladder (or intermediate-term bond fund) that will let you turn over maturing bonds into higher yielding bonds as rates rise. Look for seasoned fund managers who can shift strategies along with the market.  And think about supplementing your bond income with high quality dividend-yielding stocks.
A long-term investor looking for total return shouldn’t bet everything on bonds – or any single asset class. Often when a tidal wave puts so many investors on one side of the market, a shift is not far away. Better to balance investments between asset classes, including bonds, stocks, commodities, and foreign investments. That way no matter which way the seas shift, something is likely to keep your portfolio afloat.
Reporter: Jennifer DePaul

Related Links:
The Great American Bond Bubble (Wall Street Journal)
The Taylor Rule and the Bond Bubble (New York Times)
Deficit Cost Declines and Stimulus (Bloomberg)