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Devil’s Advocate: Bonds Are Not Safe

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This is a Devil's Advocate post.

Read enough investing advice and one of the classic “rules of thumb” is that your investments should be “diversified.” It’s hard to argue against the advice that you shouldn’t have all of your investing eggs in one basket because it’s usually sound advice. It breaks down when you start wondering which baskets you should be putting your eggs in! Should you put it in five baskets? Evenly? More in one or the other? That’s when the experts say you should follow something like the 120 Minus Your Age rule. That rule stats that you should subtract your age from 120 and put that percentage of your investments in stocks. Put the rest in bonds.

In essence, it’s saying that stocks are risky and bonds are safe. Bonds are usually safer than stocks because they aren’t subjected to the same price fluctuations, in part because the market for bonds isn’t as large or as liquid as stocks. It’s still pretty big but it’s not like stocks. You don’t have people talking about bonds as often as they talk about stocks because bonds are, well, kind of boring. They aren’t, however, 100% safe.

Why Aren’t They Safe?

The basic idea behind a bond is that it’s a loan. Companies and municipalities issue bonds to help pay for things. You buy a bond, you get a coupon each month or quarter or year, and when the bond matures, you get your money back. Sometimes there are zero coupon bonds where you get no interest but you buy the bond at a discount to face value. The bond is backed by the entity that issued it. The interest you earn off that bond is based on the credit worthiness of that entity. The riskier the entity, the higher the interest rate. Sounds pretty safe right?

Here’s where it gets tricky… bonds can be sold on the market. That means their value can fluctuate depending on demand for that particular bond and for bonds in general. The underlying value of the bond, the face value, can’t and won’t change but to reclaim that you will have to wait until maturity. The interest it pays won’t change either. The terms are set until maturity. The tricky part is that the bond’s market price can change and that can have an impact on things like a mutual fund for bonds. Your value will change and the manager can decide to sell the bond or do any number of things besides wait until maturity.

Municipalities & Companies Can Default

Many municipalities, and even more companies, can default on their bonds. Can you guess what the rate of default is? If you thought it was 0% then you’d probably be surprised to learn it was 5.5% in 2010 and 2011. It’s much higher than the 2.7% for the previous thirty-nine years, according to Moody’s.

You can avoid many of the default if you stick with general obligation bonds (health care and housing bonds accounting for 73% of defaults) but in the end, you have to really do your homework to avoid buying municipal bonds from the wrong municipalities!

Interest Rate Risk

The biggest risk is ultimately interest rate risk. When interest rates go up, bond values go down. When interest rates go down, bond values go up. That’s because a bond will pay an unchanging amount each period and how much that payment is worth will depend on the prevailing interest rates. Let’s say you can get a 10-Year Treasury Note for 1.61%. That’s 1.61% for absolutely no risk whatsoever (technically not “absolutely no risk” but you know what I mean). If that rates goes up, if the risk free rate goes up to 2%, then anything risky is now worth less than before because you’re now getting less yield for the same amount of risk.

So let’s say you have a bond that pays out 3% but you take a little bit of risk that the bond will default. You paid some amount when the 10 Year T-Note was at 1.61%. If the 10 Year T-Note now yields 2% and you want to sell that bond, you won’t be able to get the same amount you paid for it. You paid to get 1.39% of extra yield and now, with the same amount of risk, you only get 1% of extra yield. The difference has to come from somewhere and that’s in the value of the bond. If you hold it until maturity, you get the face value regardless of the market value. If you don’t, then you will have paid for the interest rate going up.

The interest rate is pretty low right now, so the risk isn’t whether rates will go up… but when.

These are just a few of risks with bonds but I think it illustrates the bigger point that bonds are, in general, safer than stocks but by no means 100% safe.

{ 4 comments, please add your thoughts now! }

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4 Responses to “Devil’s Advocate: Bonds Are Not Safe”

  1. William @ Drop Dead Money says:

    “Bonds are not safe” is a misleading statement, analogous to “it’s not safe to take a walk.” In the extreme technical sense it’s true, but in the every day sense, not so much. In other words, a good “devil’s advocate” story, forcing us to think through our assumptions.

    So, let’s see:

    The default risk, as stated (5.5% of bonds default) paints a very misleading picture. It sounds like everybody is happily whistling along when, bam! Out of nowhere comes the shocking announcement that the City of San Bernadino is going to file for bankruptcy! No warning.

    Well, that’s not how it happens, at least not most of the time. Every now and then there might be a Whoops (WPPS) default but those are one in a thousand, certainly not 5.5% of the time in any year.

    In almost all cases of default there’s plenty of warning, lots of speculation… lots of time for anybody who hates risk to get out. Those getting out may lose a sliver of their investment as the increased perception of risk drops the bond price a little when the first rumblings appear.

    In practical terms, therefore, default risk shows its face as interest rate risk. Speaking of which…

    Interest rate risk is everywhere in everything to do with investing. To anyone contemplating any investment, that should come as no surprise. (The only possible exception could be a FDIC insured savings account.)

    The practical question isn’t so much is interest rate risk there or not, it’s how escapable is the investment? For example, an investment in a rental house vs. a bond.

    If you notice or think interest rates are about to move, how quickly can you liquidate and escape the investment? In that regard, bonds beat most investments: liquidity reduces the practical risk.

    Liquidity (escapability) mitigates interest rate risk. That makes bonds safe, even from interest rate risk.

    So… nice try, DA! If you truly think bonds are not safe, cancel those plans for a picnic this weekend – you might not make it. :)

  2. You’re surely right Jim–if “safe” means one cannot lose principal, then bonds clearly are not safe. As you point out, this applies even to US Treasury bonds, unless one plans to hold the bond until maturity, taking interest rate risk off the table.

    I worry that many of the folks piling into bonds don’t understand just how quickly the value of their bond can drop when (not if) interest rates begin rising toward ‘normal’ levels. Who knows when that’s going to happen, but it will I think.

  3. Nice description of ‘interest rate risk’ – very easy to understand. Also makes it obvious that it is important to know the bond maturity date and face value before investing.

  4. David says:

    Don’t buy bonds if the bank still owns your home. You can get a guaranteed return of 6% by paying off your mortgage.

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