From the Frying Pan to the Bondfire

06/01/2009 9:39 am EST

Focus: MARKETS

Terry Savage

Author, The Savage Truth on Money

“I’ve lost so much money in my stock market funds in my 40l(k), so I’m switching to something safer—a bond fund.”

I’ve heard that statement so many times, and it makes me cringe. They’re jumping out of the proverbial equity frying pan—and into the “Bondfire”!

People don’t seem to realize you can lose just as much money in a bond fund as in a stock fund—and just as quickly. 

That’s not to say that you shouldn’t diversify your retirement investments into bonds.  A study conducted for MoneyShow.com by The Vanguard Group showed that bonds were by far the best performing asset class over the last ten years. But will that outperformance continue into the future? Before making that decision, you should understand the risks involved in bond investing.

But bonds have their own set of risks—even the bonds in the well-managed fund that’s been chosen for your 40l(k) plan.

And those risks are intensifying, as the US Treasury keeps borrowing record amounts by selling new IOUs—Treasury bills, notes, and bonds—and as the Federal Reserve keeps creating new money to bail out one industry after another.

The combination of more debt and more “money printing” is devastating for bonds, practically guaranteeing losses for bondholders as interest rates rise (as they have done already from their late December lows).

Here’s a quick look at the two basic risks in bonds:

First, there’s credit risk. Not all bonds are equally “safe.” US Treasury bonds have the highest “triple A” rating—even though our country is deeply in debt. All investment-grade bonds carry ratings ranging from AAA down to BBB-minus. 

Below that level, bonds are considered “non- investment grade,” meaning there is serious doubt about whether the company will earn enough to pay the interest, or worse, enough to repay the principle when the bonds mature. (That’s why they’re also called high-yield or junk bonds.)

A company’s financial situation may change quickly—before even the ratings agencies catch up!  (Think Chrysler and GM!) 

Some bonds tempt you with high yields. Beware: The lower the likelihood of repayment, the higher the interest rate that will be offered by a company (or municipality) that desperately needs to borrow money. Moody’s estimates that in 2009 a record 14% percent of high-yield bond issuers may default.

Always remember that a higher yield reflects higher risk, although several advisers now recommend that investors add investment-grade and high-yield corporate bonds to their portfolios.

There is another kind of risk that’s inherent when you buy bonds, even the top-rated bonds. It’s called interest rate risk. That’s the risk that you’ll lock up your money for ten or 20 years today—even in a top-rated Treasury bond—and then the general level of interest rates will move higher to offset inflation. You’ll be stuck with your low-yielding, fixed-rate bond for years.

Big mistake. When interest rates move higher, bond prices drop to compensate, so if you try to sell it, you’ll take a loss. 

For example, two months ago you could have purchased a $1,000, ten-year Treasury note with a fixed rate of 3.12%. But now the market rates on ten-year Treasurys have moved to nearly 3.75%, as the Treasury is announcing huge new bond sales to finance the deficit. So the current market value of your 3.12%, $1,000 bond has dropped to $940—if you try to sell it.

The longer the “maturity”—the future repayment date—of the bond, the greater the drop in market value when interest rates rise. That’s why you should stick to short-term bonds, two years or less, if you fear a return of inflation. That way, you’ll get a chance to reinvest sooner, at higher rates.

The only real place to “hide” from market volatility is a money market fund with those boring low yields. A bond fund may sport higher yields, but it’s not without risks.

You may disagree. There’s a multi-trillion-dollar bond market taking sides on this issue every day.  What do you think? Are you willing to take the risks to get the higher yields? Or do you think bonds have had their day? Please post a comment and join the conversation.

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