Bonds have become more popular than ever. There are three main reasons for this trend.
- Yield seeking. More investors are thinking about post-retirement income. This causes investors to search for – and frequently stretch for – yield. Bonds typically provide more income yield than stocks and this has attracted many income conscious investors.
- Risk aversion. The enormous volatility of stocks since 2008 has caused a shift in investor perceptions regarding the relative risk of owning stocks versus bonds. Bonds are considered safer; stocks are considered risky. The flight to safety has driven many investors toward bonds.
- Performance chasing. All of the above has been reinforced in the manner of a “virtuous cycle” by the strong performance of bonds. Bonds have strongly outperformed equities in recent times; indeed for most of the past three decades.
The rush into bonds has invited a whole new class of investors into an arena that they are not familiar with. This introduces very substantial risks that derive from lack of knowledge on the part of investors hungry for yield.
Bond Yield Traps
In the bond universe, there are various “traps” that investors should be aware of.
Yield versus default risk trap. There is no free lunch. The market is not dumb. In order to attain higher yield, investors are implicitly accepting higher risk. One of those risks is credit quality. Investors often brush aside default risk when they invest in bonds because of the priority of bond-holders in the capital structure. This is a mistake. Defaults are real and markets are relatively efficient. All other variables remaining equal, higher yield implies a higher probability of default. When you buy a bond with a higher yield, that yield is deceptive. At the end of the day, a certain percentage of companies default – and the higher the yield, the higher the default rate. Thus, once the default rate is factored into projected total return, the expected total return will not be much better than that of lower yielding but safer instruments.
Yield versus duration trap. Many investors knowingly or unknowingly stretch for yield by increasing the duration of their bond-holdings. The problem, again, is that there is no free lunch. Increased duration necessarily implies increased risk – via inflation and/or interest rates. While a 1% increase in the general interest rate level rates will (all other variables remaining equal) affect the value of a bond with a duration of one year by roughly 1%, a 1% increase in interest rates will affect the value of a bond with a duration of 10 years by almost 10%. Many investors are not even aware that a rise in interest rates can cause capital losses in their portfolio. However, bond investors are exposed to significant capital losses. And the higher the duration of the portfolio, the more subject it is to capital losses. With interest rates currently at historically low levels, the risk of capital losses in bond portfolios has perhaps never been higher.
The current yield trap. Many investors judge the value of a bond by its current yield – i.e. the annual income paid by the bond divided by the bond price. Unfortunately, current yield can be a very misleading indicator of value. I explain this in-depth in an article entitled, “Bonds And The Current Yield Trap.” Briefly, current yield is a misleading indicator of value when the value of the bond is priced above $100 – a relatively frequent occurrence in times such as now when interest rates are extremely low (^TNX ^TYX).
Many investors are new to bonds and do not fully understand the risks involved. Many investors think that when they buy a bond that they will receive the current yield for the life of the bond plus 100% of their principal investment at maturity. This is false.
First, the risk of default is not imaginary – it is real and must be accounted for in calculations of expected return. Second, investors that hold to high duration bonds are exposed to substantial risks of capital losses. Finally, many investors lured by relatively high current yields do not understand that their total annual return will be substantially reduced when and if the bonds they purchase (directly or through mutual funds) are above $100.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
Additional disclosure: I am short TLT.