During the last few decades, bonds have developed a reputation as being one of the safest asset classes to invest in. This is unfortunate because that false sense of security is going to take a bite out of the retirement accounts and portfolios of many investors. If you own any bonds, or are thinking about investing in them, you owe it to yourself to internalize the concepts in this article so that you clearly understand the risks that are out there.
What can be so dangerous about owning bonds? After all, purchasing a bond is really just lending money. If you’re happy with the initially agreed upon terms and the borrower doesn’t default, then your investment is safe, right? Not exactly.
There are a few nuances about owning bonds that most investors don’t clearly understand as a result of a special situation that has existed over the last three decades. We’ll get to that in a moment, but first you need to understand a little more about bonds for everything to make sense.
Understanding Bond Risks
There are two primary risks associated with owning bonds: default risk, and interest rate risk.
The first you probably understand intuitively. Default risk is the risk that the issuer (the entity you lent money to when you purchased your bond) will default. If the issuer is unable to make the interest payments and eventually return your principal, you are out that money with very little recourse.
Default risk is well-known and as a result, it is heavily monitored. Bonds are rated in terms of safety on a scale that generally runs from AAA to D, depending on the agency doing the rating. The rating of a bond is based on the ability of the issuer to meet its financial commitments. It’s very similar to a personal credit score, but exists for institutions. As long as you are sticking with investment grade bonds (BBB- and above), you generally don’t have to worry about default risk.
The real danger when it comes to bonds stems from the second of our primary risks: interest rate risk. This is a bit more complicated to understand, but please take the time to do so. Your financial future could depend on it.
Every bond has a price – initially the amount you paid for it, and subsequently what the market would pay you to buy it, and a yield – the rate of return that the bond provides. The core concept when it comes to understanding bonds is that bond prices and their yields move inversely (opposite directions) based on a specific relationship.
You might wonder what drives changes in the price that the market is willing to pay for your, or any other bond. The answer is market interest rates. Bonds are traded on a daily basis just the way stocks are. In fact, the bond market dwarfs the size of the stock market. As new bonds are created, and economic conditions change, prevailing interest rates also change.
Imagine this, let’s say you purchased a bond that has a 2% yield, and over the course of a few months market interest rates rise to 3%. Another investor who is looking to buy bonds would have no interest in purchasing your 2% bond, when he or she can get a 3% yield elsewhere. In fact, the only way you would be able to sell your bond is if you discounted the price far enough to where the new investor would receive a 3% yield based on the price they paid.
What this means is that when prevailing interest rates are rising, all existing bonds are losing value. When you hold bonds as interest rates rise, the value of those bonds can decline by a greater percentage than the yield that the bonds pay! When this happens, your bonds have a negative total return. This means that even though the bonds are paying you interest, their value is declining faster than the interest you are earning. That’s a very scary position to be in as an investor.
Now, you might think that holding a bond until it matures, rather than selling that bond at reduced prices will allow you to eliminate interest rate risk. If you believe this somewhat misleading concept, please pause and read this article for clarification. Otherwise, we’ll keep moving along.
Why Bonds Are Perceived As Safe
I mentioned earlier in this article that a special situation has existed for the past three decades, which is largely responsible for the false sense of security bond owners currently have. Let’s address that now.
The chart below shows the yield on the U.S. 10-Year Treasury. This is the best proxy for how market interest rates have behaved historically. Notice that beginning around 1982, interest rates began to decline and have been on a clear and steady path lower, going from nearly 16% to today’s roughly 2.5% level.
Based on the explanation above regarding how bond prices and interest rates are related, can you guess what happened to bond prices during this thirty-plus year period? If you said that bond prices rose, you nailed it. Over the last three decades, not only have bond investors earned interest while holding their bonds, the value (price) of those bonds has continually increased as market interest rates headed lower. This made the total returns from owning bonds very lucrative, and is a big reason why many investors believe bonds are safe.
The Dark History of Bonds
Bonds have been a great investment for the last three decades, so much so that most people have all but forgotten that bonds can go down in value. But they can, and just as bond prices rose for the last three decades, they can fall for decades at a time as well. Historically, we have experienced periods where bond prices have fallen consistently for over 40 years … gulp.
Most investors today either weren’t around for the period from 1940 to 1981, or don’t remember how bonds behaved during that time. This may come as a shock, but bonds provided negative real returns for that entire forty-plus year period. Imagine that, four decades when the value of bonds was declining faster than the interest being paid by those very same bonds. Some investors who purchased bonds in the early 1940’s had to wait almost 50 years to break even. So much for bonds being a “safe” investment. Would you want to wait 50 years just to recoup your initial investment?
So what caused this turbulent period for bond owners? If you’re following along, you can probably guess that the primary cause of all those losses was rising market interest rates. And you would be correct. Interest rates rose consistently for nearly four decades, and this meant the value of existing bonds fell precipitously.
What’s Ahead For Bond Investors?
These days investors complain about low interest rates, and rightfully so. But this brings up an important question. What happens if interest rates begin to rise, and do so for an extended period of time? Whether this will happen is up for debate, but it is a very plausible scenario.
If market interest rates begin to rise, existing bonds are going to lose value … all of them. If you hold these bonds, you may find that the value of your holdings is falling faster than the added value being provided by steady interest payments. That is, your total returns from bonds could be negative.
I hope I haven’t let the wind out of your sails entirely. Bonds can be a great investment, it just depends on timing. There are times to own bonds, and there are times to stay clear of bonds. I’ll elaborate on this a bit further before we wind things up.
When prevailing interest rates are falling, bonds can be a great investment because of their low volatility (as compared to stocks) and modest returns. Even when interest rates are low by historical standards, if they head lower in the future, bond holders will win because the value of their bonds will rise. But, and this is a big BUT, when prevailing interest rates are rising, or when other assets classes are providing significantly higher returns, bonds can either lose value, hurting your portfolio, or can be a drag on overall performance by not generating adequate returns.
This most recent three decade period of falling interest rates has had a tremendous influence on the now-standard approach to asset allocation publicized by financial professionals. You’re probably familiar with the line of thinking that says investors should be heavily invested in stocks during their younger years, and transition to almost entirely bonds by the time they retire. While popular, this approach is frightening because those promoting it don’t seem to realize the potential dangers of owning bonds under certain conditions.
If you’re currently following an approach similar to this, don’t fret, there is an innovative, new approach to asset allocation that can keep you positioned appropriately throughout changing financial conditions. It’s called dynamic asset allocation.
And if you’re looking for a better way to invest, that generates higher risk-adjusted returns, check out our investment models. The Asset Rotation Model (ARM) addresses the exact concerns discussed in this article, namely when to be positioned in stocks, bonds, and when to seek out safer alternatives because neither are appropriate.