Bonds, Danger! Bonds, Danger!

April 4, 2010

By William P. Meyers

I have touched on this topic before, but this is a good time to repeat my warning.

Bonds are usually thought of as safe. That is the wrong way to think of bonds right now (except for very short term bonds, say less than 2 years).

Bonds are the most dangerous financial investment you can own today. It does not matter whether they are U.S. treasury bonds, corporate bonds, or municipal bonds. The general danger does not lie in possible defaults, though of course individual bond issuers could go bankrupt and default.

Many investors, including individuals whose investments come from 401k and IRA accounts, had little or no experience with bonds prior to the Panic of 2008. Typically, after taking significant losses in the stock market or in real-estate investments, individuals and sometimes even large entities like pension funds wanted some place to park their cash. They were advised to buy bonds. This advice was self-serving by brokers, who could take fees for buying the bonds, but would not get fees if they left the money in the form of cash.

Under normal circumstances bonds play a ballast-like role in investment portfolios. Normally they do not fluctuate in value as much as stocks and produced a decent long-term rate of return that is higher than you would get on a CD of similar term. Returns for a given length of time vary mainly according to the perceived risk of the entity doing the issuing, so the U.S. Government pays the lowest interest, solid corporations a middling interest rate, and weaker entities pay "junk bond" interest rates. Short term rates are usually much lower than long term rates, but the differential is affected by the outlook for inflation.

Underlying interest rates are typically set by the Federal Reserve, but even the Fed cannot fight market forces forever. Right now real short to medium term interest rates on Federal debt don't even cover the loss of principal from the effects of inflation. The Federal Reserve is keeping interest rates artificially low to help revive the economy and to keep the interest on the federal debt a relatively low percentage of the federal budget.

But the danger in bonds is not in the low interest rates they are paying today. It is not even in the fact that people who were 100% in bonds in 2009 lost out on a major stock market rally. And what I am going to point to should not be a problem with balanced portfolios that include appropriate ratios of bonds with stocks or other investments.

But if you are 100% in bonds, you had best get out, or largely out, while you still can, before everyone realizes what is happening.

Bond interest rates are highly likely to rise. And they may rise rapidly once they start rising, regardless of how the Fed tries to fight market forces.

If your broker put you in bonds or bond funds, you might think that higher interest rates is a good thing. After all, you have been getting about 2% interest (maybe 3.5% if you are all in long term bonds) for a couple of years now; that seems more like being a chump than an investor. Surely it is better for bonds to be at say, 6%? Isn't that a pretty nice return on a safe investment, as opposed to chewing your nails about stocks or real estate or commodity prices?

The problem comes when you (or your broker, or bond fund manager) tries to sell your 3% bonds to buy 6% bonds (note how I have made the math easy!). Say both bonds terminate the same year, say 2020. Who wants to buy a bond that is going to make 3% interest for another 20 years when they could buy a new bond at 6%? Only one kind of trader: the kind that will get a deep discount on the bond. Like say a 30% discount. Because for a thousand dollar bond, principal plus (simple) interest at 6% for ten years givens you a total of $1600. Pay a thousand, get $600. But your old bond will pay only $300 interest over the remaining ten years. So to be worth the same amount of money, the buyer would only pay $700 for the bond itself (getting, in the end, $1000 principal and $300 interest for $700; making the same $600). You, who foolishly were in 100% long bonds, suddenly have lost 30% of your life savings just because interest rates have gone up.

And they will go up, unless we are hit by a global Depression that makes the Panic of 2008 look like an ice-cream party. The indebtedness of the Federal government keeps ballooning, and that is, so far, while paying low interest rates. You know those penalty interest rates credit card companies like to charge their most unfortunate, weakest customers? That is the direction we are probably headed in, if taxes are not increased and expenses reduced to quickly balance the budget. The economy is reviving, but that won't increase government tax revenues fast enough to make up for reckless spending and ballooning debt payments.

No one in their right mind should be loaning the United States of America money at under 10% these days, to compensate for the default and inflation risk. Now that you have thought about it, I'm sure that you as a rational individual would not do that. But tens of millions of Americans depend on mutual funds, brokers, and financial advisers to manage their investments, and they are being told to keep their money in federal bond funds. It is bad advice brought to you by the same pack of jackals and fools who brought you the Panic of 2008. It is up to you to stop playing the fool and to warn your friends.

Most publicly traded American corporations are much sounder than the federal government right now, and so should be able to issue bonds at less than the government rates. But when federal bond rates go up, they become comparisons for all bonds. That will likely force corporate bond rates up as well, causing their principal value to weaken. So if you can get out of corporate bonds before the crisis, do it.


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Copyright 2010 William P. Meyers