So why put money in bonds? Let’s have a look at what bonds are so we can understand why they are “safe.”
While we think of bonds as investments, they ironically represent debt. What happens is that when the government or a company wants to raise money, one way they will do so is to issue bonds – meaning, investors will purchase bonds (usually in $1,000 increments) from the issuer (the government or company) in exchange for a promise of future payments plus interest as their return on investment. Bonds can be for a duration of anywhere from 3 month to 30 year bonds. They all vary depending on the issuer. Typically, you’ll also see either a semi-annual (twice a year) or single interest payment on the bond; and at the end of the term of the bond, you’ll get your initial investment back. So a bond represents debt for the issuer. They issue a bond to get money now for a project and have to pay you back over time. They are in debt to you (the bond holder).
From the standpoint of the government, the Treasury issues new bonds frequently to finance the national debt. We can’t pay for our spending as we go, so we’ll issue debt now to get money now, and will pay it back later. Many countries purchase our debt issuance. For instance, China holds a large amount of U.S. treasuries issues. Thus, the U.S. is in debt to China for financing our spending. See a long-term problem here? But I digress…
The below gives you an idea on bond payments and the cash flows that come from them (single annual coupon payment).
So why is a bond “safe”? Because the issuer is bound by the terms of the bond issue and you get predictable income in return (assuming the issuer doesn’t default on the promise to pay). In an uncertain environment when you may have a negative rate of return on your stock investments, it sounds pretty good to have a “sure thing” like bonds, huh?
A lot of people have been thinking so too.
Last year, retail investors put over $380 billion into bond mutual funds. This year, another $240 billion has gone in. In contrast, over $75 billion has come out of equity (stock based) funds this year. Last year, it was more to the tune of $150 billion coming out of equities…yikes! That’s a lot of money moving out of the stock market and into the bond market…
Let’s stop right here and make a big distinction between bonds and bond funds.
So far, I’ve been referring to “bonds” in a generic sense. Up until now, talk of bonds has been academic for the purpose of understanding the structure of a bond and how its “safety” is derived. From here on out, I will be talking about “bond funds”.
When I say “bond funds” we are talking about funds (similar to a mutual fund) that are comprised of many types of bonds and bonds with many different durations (for instance a bond may be comprised of 3 month bonds, 1 year bonds, corporate bonds, municipal bonds, 30 year Treasuries, etc.). Funds that hold bonds typically don’t buy them and hold them for the entire life of the bonds. Bond funds employ strategies to buy and sell bonds before they reach maturity based on changing interest rate structures, yield to maturities, and call provisions. Sound confusing? It is, actually. Bonds surprisingly are a lot more complex than stocks if you choose to do anything other than to buy and hold them.
What’s important to understand; however, is that bonds work different than stocks in regards to interest rates and the interest rate can affect the price/value of the bond. If you are to understand one thing about bonds and bond funds, understand this: Bond values and interest rates have an inverse relationship. That means that when one goes up, the other goes down – and visa versa. For instance, if interest rates rise, prices of bonds decrease. Conversely, if interest rates decrease, prices of bonds increase.
Why? It has to do with the valuation of a bond. Think about it…if you hold a bond that is promising a 5% coupon rate, but you can now purchase a bond with a 6% coupon rate in the market, the better deal is to go with the 6% rate, right? Who would buy your 5% bond now? Well, you can’t adjust the interest rate to match the 6%, but you can adjust the price of the bond to entice buyers to buy your bond…so you’d lower the price to attract a buyer.
Additionally, it’s also important to know that the longer the maturity of the bond, the more sensitive the return will be to a change in interest rates. So a one-year bond is going to be less sensitive to an interest rate change than would be a 30-year bond. To compensate for this “interest rate risk”, longer term bonds have more yield (pay more interest) than do shorter term bonds. The reason: to entice investors to buy longer term bonds, they need to pay them more interest for them to justify the risk being taken.
Very theoretical stuff, I know. Let’s try a quick example just to drive home the point. If you own bonds with a five-year, 10-year, and 30-year maturity and interest rates go up 1 percent in one year, the following would happen: the five-year bond will lose 0.5 percent of its value, the 10-year bond would fall 4 percent, and the 30-year bond would lose 12 percent! Ouch!
As of this writing, yields on US Treasury Bonds were: 0.11% for 3 month; 0.16% for 6 month; 0.36% for 2 year; 0.51% for 3 year; 1.13% for 5 year; 2.53% for 10 year; 3.96% for 30 year. These yields get plotted on a “yield curve”…something that would look like this:
Now that you have this understanding and background, I’ll share with you my concern about the current state of the bond markets.
As we noted, in times of economic uncertainty, what you have is a “flight to safety” and a lot of people move out of equities and move into bonds. As was noted, a ton of money has moved into the bond markets lately. Here’s the concerning part: Currently, the Federal funds rate and thus interest rates of many “safe” bonds (government bonds) are at major lows. With lowering interest rates and a large market demand for these safe bonds, prices have been pushed higher. Now, do you think that the Federal funds rate will stay low forever? No! Even though we have historically low rates, and even face another round of money injection into the economy (the Fed’s “Quantitative Easing” being talked about), eventually, the Fed will take action and we will be facing an inflationary environment with interest rates on the rise. So, as was discussed, if interest rates increase, prices of bonds decrease. The risk that is now forming in the bond markets is that bond funds will see large loses once interest rates begin to climb – because the value (the price) of those underlying bonds in the fund will decline. Participants in those bond funds will start to realize investment loses.
Now, far be it for me to call a spade a spade, but I’d venture to say we’re experiencing a bond bubble. It’s as if we have a complete reversal of the dot-com bubble of the late 1990s. Everyone was high on stocks and money was pouring in. Now everyone is scared and money is pouring into the bond markets. This looks like classic herd mentality to me.
In light of the above information, I’d recommend that you research your current investment mix to see what your exposure is to bonds…specifically long-term bonds. FYI - Any mutual fund that you hold typically has a bond component as well - this problem is not just specific only to bond funds.
I’m not advocating that you bail out of bonds or bond funds altogether, but you need to understand and know what your risk exposure is to a bond bubble burst. Any bond fund or mutual fund that contains bonds that are TIPS (Treasury Inflation-Protected Securities) or low-duration bonds (short maturity bonds) will be relatively safe. TIPS provide protection against inflation, as they are structured so that the principal (the value) increases with inflation and decreases with deflation (i.e., the principal is positively correlated to inflation). As was already mentioned, bonds with shorter terms (3 month or 1 year bonds, for example) aren’t as affected by changes in interest rates and aren’t as subject to as much loss. Thus, low-duration bonds have less volatility because you are not locked into a long-term yield. This would be more advantageous in a rising interest rate environment.
As a side note, when interest rates begin going up, that is generally a sign that the economy is on more solid footing. A way to offset some of the bond risk is to invest in funds that have high yielding dividend stocks, say anywhere between a 4 and 7 percent dividend yield. This will provide a consistent stream of income from the routine dividend payments, and will also benefit from capital appreciation in an improving economic environment.
If you want to read more about bonds and the hypothesized bond bubble, just do a search for “bond bubble” online and I’m sure you can find people far more intelligent than myself discussing these issues at length.
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