Is it Too Late for Bonds?

10/11/2012 10:00 am EST

Focus: BONDS

Terry Savage

Author, The Savage Truth on Money

Trillions of dollars in recent bond and bond-fund investments will suffer when interest rates inevitably rise, writes MoneyShow's Terry Savage.

Do you own stocks or stock mutual funds? Or have you sworn off the stock market as too risky, too dangerous, or too volatile? Have you switched to something “safer”—like bond funds?

If so, like millions of American investors, you could be making one of the biggest mistakes of your investing lifetime.

The Dow Jones Industrial Average has more than doubled since making its market bottom just above 6,547 on March 9, 2009—just when people were dumping stocks. We are now less than four percentage points away from the all-time high reached October 9, 2007.

But instead of riding this rising tide, Americans have been selling all the way up. Since March 2009, investors have pulled $138 billion out of stock-market mutual funds and exchange traded funds that invest in stocks. During that same period, they have added more than $1 trillion to bond funds, in search of higher, more reliable yields.

It’s one thing to withdraw profits and set some profits aside for safety as your gains grow. But it’s quite another thing to literally jump out of the frying pan and into the fire!

Yet that is exactly what some novice investors are doing when they switch from stock to bond funds—not knowing that bonds can lose market value even more quickly than stocks.

The Dangers of Bonds
Broad-based bond market losses are a phenomenon that hasn’t been seen since the late 1970s—a period that few of today’s market participants remember.

So here’s a basic lesson in how bonds can create big losses for you. And these principles apply to individual bonds and bond funds, as well as to corporate, government, and municipal bonds.

There are two risks in owning bonds. The one most commonly recognized is “credit risk.” Investors should always worry about the credit quality of the bond issuer. After all, you are lending money to a business or government, so you want to be assured they will be in a position to pay the interest on a regular basis, and to repay your principal (the amount of the face value of the bond) at maturity.

It’s reasonably easy to solve the problem of credit risk. Bonds are rated by various agencies as to their creditworthiness. You can stick to top-rated bonds and mitigate this risk. And you can diversify in a bond fund to spread the risk. But credit risk isn’t the only bond risk.

The second major risk of losing money in bonds is “interest-rate risk.” Since bond interest rates have been falling for more than 30 years, today’s investors have never experienced the kind of losses that come to all bonds when interest rates, in general, start to rise.

Here’s how it works. Let’s suppose that you don’t want the risks of stocks today, and you’re quite annoyed that short-term CDs and Treasury bills pay less than 0.25%. So you start searching for higher yields.

You don’t want “risky” bonds, so you settle on either a ten-year Treasury note, yielding about 1.7%, or a 30-year Treasury bond, yielding about 2.9%. You figure they will give you more interest—and keep you safe.

But what if interest rates start rising again? Let’s say you bought that 30-year Treasury bond today, but interest rates start moving higher. In the future, the Treasury needs to sell more bonds to borrow more money to fund its deficit. But these newer bonds are sold with a yield of 5%. (Keep in mind that in the early 1980s, the Treasury sold 30-year bonds with interest rates of more than 12%!)

If interest rates do rise, then people still holding cash could buy bonds with higher yields. So what happens to the market value of your old 2.9% bonds? Their market value falls! Your $1,000 bond yielding 2.9% could be worth only $600 if you need to sell it to raise cash.

And if you decide not to sell and take that loss, then you’re suffering with locked-in lower yields! That’s called “interest rate risk.” You must understand that risk before you buy bonds:

When interest rates rise, bond prices fall.

The longer the maturity of your bond, the greater the decline in market value when interest rates rise.

That’s why you should keep your maturities short if you fear higher interest rates in the future. With a two-year Treasury note, you’ll be able to re-invest in higher yielding securities as rates start to rise. And you won’t be trapped with long-term bond market losses.

Why Interest Rates Will Rise
Since the Fed has promised to “keep rates low,” you might be wondering why and how interest rates might rise. Yes, the Fed has been punishing savers with low interest rates in an attempt to stimulate the economy and get America growing again. But at some point, the bond market will overwhelm the Fed’s best intentions—and rates will rise.

The Fed has created trillions of dollars through “quantitative easing”—which is just another way of “printing money” and putting it into the system. Now the Fed has promised to create another $40 billion per month. All that new money without economic growth is sowing the seeds of inflation.

And during inflationary periods, when people expect the future buying power of their money to fall, they demand higher interest rates before they will lend—even to the US government. No one wants to get their money back in ten or 30 years, knowing it will buy less. Higher interest rates compensate for loss of buying power.

As long as the US government keeps running deficits, it will keep borrowing. As long as the Fed is “printing” the money to facilitate this borrowing, the money will lose value. And when this is generally recognized, interest rates will rise. And then the bonds you buy today, locking in low rates for years, will lose market value.

Investors who see higher rates coming will rush to sell their old, low-yielding bonds. That will put even more downward pressure on bond prices.

Once you understand how bonds can lose market value just like stocks, you’re likely to be a bit more careful about what percentage of your assets you move into bonds, just to gain a slight edge in interest rates today.

The $1 trillion that has flowed into bond funds in the last four years will teach its owners a painful lesson. And that’s The Savage Truth.
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