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There has been a dramatic global change over the past few years as investors have sold stocks and bought bonds. The Financial Times recently announced that British pension funds are holding more bonds than stocks for the first time in over 50 years. Part of the attitude shift flows from fear generated by catastrophic stock market declines during 2000-03 and 2007-09. Part also flows from the gradual aging of the investor base, as more people move toward stages in which they can afford less risk and need greater income assurance. The primary driver of the shift, however, is almost certainly performance chasing, which is always what drives the majority of investors. That pursuit accounts for the unfortunate consequence of people buying most heavily at market highs and selling most heavily at market lows.

Since the turn of the century, bonds have markedly outperformed stocks. And now that the Federal Reserve has begun to buy massive quantities of bonds directly, both high and low quality alike, interest rates have fallen to near all-time lows. The Fed has further enthused bond investors by promising to keep rates at current depressed levels into 2015. If they retain that resolve and as long as they are able to accomplish their goal, bonds -- at least treasuries and agencies -- should remain relatively safe. At current minimal rates, however, top quality debt will provide very little return. Earning any appreciable yield requires investing further down the quality scale.

Unfortunately, a great many bond investors fail to appreciate how much risk attends most fixed income portfolios today. Fed pledges and best intentions notwithstanding, there is no guarantee that the Fed will succeed in keeping rates at rock-bottom levels. Should inflation unexpectedly begin to rise aggressively, rates would undoubtedly rise, possibly even propelled by the Fed reversing its stance and raising short-term rates. Political winds could shift, and an outcry could arise against the money printing that supports record levels of Fed bond purchases. Political or economic factors outside U.S. borders could precipitate heavy bond selling. Foreign holders now own 17% of all U.S. credit market instruments. China and Japan, holding roughly $1 trillion each, own giant amounts of our debt. Should either -- or any of several other large holders -- choose to reduce their positions significantly, they would exert powerful upward pressure on U.S. rates. Even top quality bonds would lose value if rates rise.

Far greater danger exists for lower quality bond portfolios, to which many investors have turned to scratch out a little extra yield. So far, that strategy has succeeded under powerful central bank support. Europe is in recession, much of the rest of the world is slowing, and the U.S. is struggling to stay on a growth path despite massive amounts of government support. Should the widely discussed Fiscal Cliff or any number of other factors tip the U.S into recession, lower quality debt rates will almost certainly rise, as fears of default potential grow. Of course, if rates rise at the higher quality end of the spectrum, bonds of any quality will feel that effect. Even short of default, bond portfolios could suffer significant losses if rates rise appreciably for any reason.

By way of precedent, it is instructive to remember that when the last rising rate cycle began in the early 1940s, it lasted for four decades. Over that span, bond investors failed even to keep pace with inflation. In fact, for four decades, keeping money in risk-free Treasury bills was more productive than holding virtually any corporate or government bonds.

Should the Fed succeed in keeping interest rates down for a few more years, bond investors might be able to eke out a bit more return. To keep that return, however, bond holders will eventually have to make a timely sale decision or hold bonds to maturity and hope that the return has not been eaten away by inflation.

Source: Yield Comes With Risk