Fixed Income Isn't Risk-Free

Many investors try to keep things as simple as possible. One way to simplify investing is to take certain concepts and ideas and condense them into two opposing viewpoints or categories. Some of these are just definitions: Bulls think the market will go up, while bears think the market will fall. Others, however, grow into platitudes that are only superficially correct. One might think that all growth investors follow high-priced stocks that have the potential to become the next big thing, while all value investors look at companies that are out of favor and whose prices have fallen to levels at which they look attractive. Some believe that U.S. companies are always safer than foreign businesses. Simplifying your understanding of investing isn't bad -- until you start sacrificing truth and accuracy.

One of the most common investing maxims that people follow is the idea that stocks are risky while bonds are safe. From such a simple statement flows a multitude of investment strategies and conclusions about how best to manage your money. Many asset allocation strategies recommended by financial planners have, as their foundation, the fact that as you age, you should reduce your exposure to equity investments and increase the amount of fixed-income securities you hold.

Some mutual funds that focus on investors saving for retirement actually take care of adjusting your investment allocations for you. All you have to do is pick a target date for your retirement, and the fund takes care of making appropriate trades that keep your allocations in line with basic rules. Marketing materials often explain these strategies by suggesting that as you age, you should take less risk, and increasing your exposure to fixed-income securities helps you lower your risk.

As an investor, it's easy to decide that if you want to be completely safe, you should just take all your money and invest it in fixed-income securities. The point at which you draw that inference, however, is the point at which the simplified notion that bonds are safe becomes counterproductive. The fact is that bonds have risks of their own, and investing in bonds is far from completely safe.

The best of both worlds?
Looking at recent bond returns, however, you'd probably arrive at a much different conclusion. Indeed, the past 25 years have been extraordinary for Treasury bond returns, as bonds with the longest maturities have risen in value more than 30% in a single year. Furthermore, these high annual returns have not been isolated events. There have been four years in which bond prices rose more than 20% and 10 years in which they rose 10% or more. These big years have pushed the overall average return on bonds over the past 25 years to nearly 10%.

Meanwhile, looking at the same period, these high returns have come with relatively low risk. When you consider both price changes and regular interest payments, long-bond investors have lost money in only three of the last 25 years, and none of those years involved a loss of 10% or more. In contrast, while the same 25-year period has been very positive for stocks as well as bonds, stocks have suffered much more violent downturns, including the crash of 1987 and the bear market of 2000-2002 that brought the Nasdaq Composite down more than 70%.

Since the long-term historical return on stocks isn't much higher than 10%, it's tempting for investors to decide that they might as well stick with a sure thing by investing in bonds. Since many financial planners are currently advising clients that returns on stocks are unlikely to maintain the pace of the boom times in the 1980s and 1990s, bond investors who are approaching retirement and the time at which they'll need to draw on their savings may actually believe they can outperform equities with lower risk.

The boom is over
The problem with this analysis is that the strong performance of the bond market over the past 25 years is the result of a unique confluence of factors that many believe may never happen again -- or at least not any time soon. In the late 1970s and early 1980s, the American economy was suffering from a barrage of hardships, including oil price shocks, Middle East tensions, high levels of inflation and unemployment, and a general lack of confidence. The same short-term Treasury bills that brought less than 1% in interest just a couple of years ago routinely brought between 13% and 18% returns in the early 1980s, and long-term Treasury bonds yielded as much as 15% at auction. Because prices of existing bonds react favorably to falling interest rates, as rates steadily fell from those double-digit levels to the current low levels between 4% and 5%, bonds appreciated in a way they never had before.

With interest rates as low as they currently are, it's nearly impossible mathematically for bond prices to rise in a similar fashion, as rates would have to fall further from these historical lows. Meanwhile, bond investors who are locking in these relatively low rates run the opposite risk -- that interest rates will rise, causing their bonds to lose value. Although higher rates are far from a certainty at this point, it's pretty clear that the days of constant double-digit bond returns are over.

Like many investments, bonds have a place in the portfolios of most investors. However, don't be fooled by the illusion that bonds are completely safe. Bond prices can be as volatile as stock prices, and unless you're mentally prepared for the possibility of losses, investing in bonds may be a big disappointment for you.

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The Motley Fool'sChampion Fundsnewsletter isn't just about investing in stocks. Shannon Zimmerman, the Fool's mutual fund guru, scopes out funds that cover the full range of available investments, including bonds and other fixed-income securities. Take a look at Shannon's analysis free for 30 days by taking advantage of a free trial.

Fool contributor Dan Caplinger has kept part of his portfolio in bonds throughout the ups and downs of interest-rate movements. He holds savings bonds, Treasury securities, and a number of bond mutual funds. The Fool's disclosure policy eliminates all risk.


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