Beware of Bonds

Beware of Bonds

As some people have started to realize over the last couple months, bonds can be dangerous for your investment health.  Even so called “safe” bonds can be dangerous and even more dangerous than “risky” bonds at times.  There is no such thing as a “risk-free” bond.  While a bond may have low credit risk (i.e. low chance of bankruptcy) it still will suffer from interest rate risk, inflation risk, and/or opportunity risk.  The lower interest rates go the lower the future return and the more dangerous a bond becomes. 

Let’s start with inflation risk.  If you purchase a 10-year U.S. Treasury Bond, for example, with a yield of 5% and the current inflation rate is 3% then you are still earning a “real” (inflation-adjusted) return of 2% (5% -3% = 2%).  However, if interest rates are 2% and inflation is 3% then you have a negative real return of 1% (2% - 3% = -1%).  By investing in the 2% bond you are losing purchasing power.  

Interest rate risk also increases with low interest rates.  In this example let’s assume you own a bond with a yield of 5% and duration of 5.  Duration is simply a measure of the interest rate sensitivity of a bond.   So, in this example, let’s assume that over the next year interest rates increase by 1%, then your bond with a duration of 5 will DECREASE in price by 5%.  You gain 5% in interest over the year, but the price of the bond has dropped 5%, so you have broken even (+5% -5% = 0).  With a bond yielding 2% with duration of 5 assuming the same scenario with interest rates increasing by 1% over the next year then you will lose 3%  as the price of your bond drops 5% while the interest you earn is only 2% (+2% - 5% = -3%).  This ignores another factor.  If you have two bonds with the same maturity and different coupons then the duration for the bonds will be different as the lower coupon bond will have a greater duration.  Assuming both bonds have the same maturity date then the 5% bond may have a duration of 5, while the 2% bond may have a duration of 7.  As interest rates increase by 1% the 2% bond decreases in value 7% while the 5% bond’s price only drops 5%.  This also works in reverse, so if rates decrease the price of the higher duration bond increases by more. 

Over the last couple months rates have increased dramatically causing significant losses for those holding intermediate-to-long duration bonds.  I’ve been shorting (betting the price will drop) the 20+ year treasury bond ETF for a little while now and increased my exposure as interest rates decreased earlier this year.  Since then interest rates have increased significantly causing the price to drop.  This means if I wanted to cover my short (close my position) I will make an okay profit.  However, over the next several years I expect interest rates to continue to increase and bond prices to decrease more, therefore hopefully creating a larger profit for myself.  This position has its risk though, so I would not recommend it unless you understand the risks.  If you want a better explanation of the pros and cons of this position let me know.

Finally, if you invest in 3 month U.S. Treasury bills you could argue that you have limited to zero interest rate and credit risk.  However, in this environment of near 0% yields on these assets they not only suffer from inflation risk, but also opportunity risk.  If you haven’t been paying attention stock prices have been going up, so if you’ve been invested in short-term assets like money market you have missed out on some large gains.  This is the opportunity risk that you obtain when you purchase lower risk/lower return assets. 

 
There are other risks to certain bonds or for foreign investors, for example, currency risk.  But for U.S. investors investing in dollar-denominated assets this is not a concern.   Hopefully, I’ve shown that even “low risk” bonds can actually be quite risky and that the lower the yield the higher the risk.