Why Investing In Bonds Is Not As Safe As You Think

Includes: AGG, BND, TY
by: Scot Hicks

Most people are attracted to the treasuries because of safety. Those investors who eschew risk often migrate to those investments with as little downside as possible. Makes sense, right? Perhaps you have worked for a long time to accumulate a material amount of wealth and you wish to be in a protective mode. Maybe you wish to guard against losses for your heirs. All wonderful reasons to be a bond investor, especially in light of the decade's long run the market has been on. However, what if you need to exit this cozy, warm investment before it matures? What if interest rates go from the rock-bottom basement and bounce just a couple percent? Then what?

First, let me say that I understand the ultimate attraction of US interest rate securities and that is because they are backed by the US government. Beleaguered as it is, most investors would rather trust the US government when it comes to backing a security than virtually anything else. What I am talking about in terms of risk is market risk. What happens when the market does things that we did not anticipate?

My job today is to shine a light on the fine print of your purchase agreement for those bonds and hopefully make you think a bit. Maybe consider diversifying your portfolio. Now, there is a novel concept. First, let's look at some concepts and see if there is any reason for you to worry.

What happens to your bonds when interest rates go up? If you hold onto the bond until the maturity date, there is zero impact to your investment. You would simply redeem the bond for the par (value you paid for the bond) at maturity. The trouble begins when you need to sell your bond before the maturity date. Since you are locking up your money for five, ten years and longer, the possibility of needing access to those funds is very real.

The amount of the potential losses will depend on maturity dates and of course, how high interest rates rise. To illustrate the financial impact, I will draw from a Seeking Alpha article written in January of 2012 by Difu Wu, Entitled: Why Bonds Are No Longer Sound Investments

"To see how much damage investors in high grade bonds can suffer if they buy bonds today, at 2% yield for 10-year T-bond and 3% yield for 30-year T-bond, assume that interest rates merely return to their historic averages, about 4% for the 10-year bond and 6% for the 30-year bond. Price for the $1000 face value 10-yr bond with 2% coupon rate would fall to ($20)*(1-1/(1+0.04)^10)/0.04)+ $1000/(1+0.04)^10 = $162.22 + $675.56 = $837.78, a loss of over 16%.

Price for the $1000 face value 30-yr bond with 3% coupon rate would fall to ($30)*(1-1/(1+0.06)^30)/0.06)+ $1000/(1+0.06)^30 = $412.95 + $174.11 = $587.06, a loss of over 41%, which is a hefty loss for an investment that is supposed to be "conservative.

But if interest rates overshoot (as markets tend to overcorrect when they revert to the mean) and go to 6% for the 10-year bond and 9% for the 30-year bond, what happens?

Price for the $1000 face value 10-yr bond with 2% coupon rate would fall to ($20)*(1-1/(1+0.06)^10)/0.06)+ $1000/(1+0.06)^10 = $147.20 + $558.39 = $705.59, a loss of over 29%.

Price for the $1000 face value 30-yr bond with 3% coupon rate would fall to ($30)*(1-1/(1+0.09)^30)/0.09)+ $1000/(1+0.09)^30 = $308.21 + $75.37 = $383.58, a loss of over 61%! Note that this loss is even worse than that experienced by the stock market from the absolute top to the absolute bottom in the severe 2007-2009 bear market."

So much for the "safe" investment!

Another concern is for those in bond funds. Since bond funds typically hold instruments of varying maturities, the odds of the value of the fund dropping when interest rates rise is very real. The flip side is that these are professionally managed funds that are employing risk management.

So, where does an investor go from here? I believe that the first step for all investors is to become more informed. Understand what is in your portfolio today and evaluate your risk and especially understand the impact to your portfolio should rates go up. If you wish to become more aggressive there are various ways in which to position yourself to possibly benefit should rates go up. One path is to look at shorting futures contract like 30 year US Bonds (US) and 10-year Notes (NYSE:TY). Further, ETF's offer the ability to establish a short position. The two largest ones are iShares Barclays Aggregate Bond Fund (NYSEARCA: AGG) and the Vanguard Total Bond Market ETF (NYSEARCA: BND).

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

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