Bonds: So Much More Dangerous Than You Think

You may not have noticed it, but bonds haven't done well lately. Since last July, the iShares Barclays 7-10 Year Treasury Bond Fund has lost 2% of its value, while a version that invests in bonds with longer maturities has lost more than 7% (both include interest payments). With the yield on 10-year Treasuries rising from 1.5% last summer to about 2% today, many are realizing for the first time that it's possible to lose money investing in bonds.

But here's what's unnerving: Shown in historical context, the rise in yields since last summer is so irrelevant that it's hardly visible (far right corner):

Source: Robert Shiller, Yale.

If you are one of the investors who has helped to plow more than $1 trillion into bonds since 2008, ask yourself a simple question. The tiny blip on the far right of this chart has caused bonds to lose value. So what happens if interest rates return to historically normal -- or above-average -- levels?

The losses could be devastating.

Keep in mind what we're talking about when discussing bond losses. If you purchase a bond at par and hold it until maturity, you will receive your principal back, provided the issuer doesn't default. But what happens in the interim is another story. Bond prices move inversely to interest rates, rising as rates fall and falling when rates rise. If interest rates rise and you sell a bond before its maturity, or if you own a mutual fund run by a manager who chooses to do so, you may receive back less than your original investment -- far, less in fact. Richard Barley of The Wall Street Journal recently pointed out that for every percentage point interest rates rise, 10-year Treasuries "face a drop in price of nearly nine percentage points."

This is to say nothing of inflation. Since 2010 inflation has averaged a bit more than 2% per year; since 1947, it has averaged 3.5% a year. Yet the interest rate is now 0.8% on five-year Treasury bonds and 3.2% on 30-year bonds. At current interest rates and inflation rates, people buying five-year bonds are going to the government and saying: "Here's $100. Over the next five years, give me back the equivalent of $93." It sounds crazy, but that's really what's going on.

Why would anyone choose this fate? There are a couple of explanations. One is that investors are fine with small losses in bonds if they think the alternative is large losses in stocks. Given that they've been burned by two 40% peak-to-trough stock crashes in the last 12 years, this viewpoint is understandable (though ultimately wrong).

Another, more dangerous explanation is that bond buyers have become so accustomed to the 30-year bull market in bonds that they lack the imagination to picture interest rates rising any more than a blip. Markets have painfully short memories. Five or 10 years is usually all it takes for investors to forget what a bear market feels like and resume making bad decisions. But the last time bonds had a bad year was 1994, and the last awful year took place during Ronald Reagan's first term. In investors' minds, the bond bloodbath of the 1970s and 1980s is such ancient history that it's easy to pretend it never happened. That leads to the even more deluded notion that it can't happen in the future.

But let's look at what happened to bonds the last time interest rates were near current levels, in the 1940s:

Average annual real returns

Period

10-Year Treasuries

30-Year Treasuries

Corporate bonds

1940-1949

(2.52%)

(2.79%)

(1.36%)

1950-1959

(1.80%)

(2.67%)

(2.02%)

1960-1969

0.23%

(1.96%)

(1.90%)

1970-1979

(1.19%)

(3.40%)

(1.88%)

Source: Deutsche Bank Long-Term Asset Return Study.

These average annual losses might look small, but over time they add up fast. Someone investing in 10-year Treasuries from 1940 to 1979 lost more than 40% of their money in real terms. Those in 30-year bonds lost more than two-thirds of their capital after inflation.

That isn't a forecast of what might happen to bonds over the next four decades, but it's certainly possible, if not likely. And how many bond investors realize it? Few, I'm afraid. U.S. households owned $945 billion worth of Treasuries as of last September, up from $762 billion in 2009, according to the Federal Reserve.

At a conference two years ago, Wharton finance professor Jeremy Siegel laid out the history of stocks and bonds to a roomful of journalists: "You have never lost money in stocks over any 20-year period, but you have wiped out half your portfolio in bonds. So which is the riskier asset?"

The question answers itself. 

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  • Report this Comment On February 11, 2013, at 6:22 PM, xetn wrote:

    Bonds: the real bubble. When the bubble bursts, what will happen to stocks?

  • Report this Comment On February 11, 2013, at 6:46 PM, jt0053 wrote:

    My bond funds have done excellent over the last year, most over 5% some over 10%, 1yr return... j/s

  • Report this Comment On February 11, 2013, at 7:20 PM, yragca wrote:

    overall Treasury rates are most influenced by inflation (doubt if it's going anywhere for a few years) and Fed policy (and Ben has told us he's going to keep the rates near zero for a long time, if he can). So I respectively disagree with this call. I expect the 10 and 30 year rates to reach close to cycle lows again, if not lower. And the money in bonds if that occurs will be made in the capital gain on the bond--not the interest rate. Check out the Japanese experience over the last 20 years--and also where the bund has traded.

    Sushi anyone?

  • Report this Comment On February 11, 2013, at 7:29 PM, Lazarill0 wrote:

    @xetn:

    Well, I assume that's a rhetorical question, but stocks will rise. No one will get too overly excited about real estate any time too soon. So it's either stocks or -- I hate to say -- gold. I'd hate to see another run up in gold, but folks seem skittish enough to let it happen.

    There are plenty of people with money, and they have to put it somewhere...

  • Report this Comment On February 11, 2013, at 9:08 PM, marei wrote:

    "A fool and his money are soon parted." Almost one trillion dollars left to rot on the sidelines. Anyone who had invested in the Dow Jones Industrial Average stocks on March 9th, 2009 would have seen the investment more than double in the years since.--Tom Reilly

  • Report this Comment On February 11, 2013, at 9:14 PM, captam wrote:

    When I invest in bonds, I do precisely that and do not buy "bond funds". I do it for the long term for fixed income and I know exactly what my return will be ( it never changes) with the yield continuing to maturity, when I will get back the face value of the bond ( unless the issuer has gone bust).

    If I have paid 108 for a face value of 100 I am not stupid enough not to know that upon maturity I will get back only 100 but if i have been regularly receiving over 8% coupon over many years ( with barely any risk) when other poor misers having earning only 0.25% on their savings accounts I am content with my return. The 8% premium I paid to purchase the bond is peanuts when I compare it with the overall return over several years.

    When you write articles on bonds please distinguish between bonds and bond funds. The latter are for short term gamblers.

  • Report this Comment On February 11, 2013, at 9:53 PM, LALoft wrote:

    The writer mentions the loss from 1940 to 1979, but fails to mention what the bonds returned from 1980 to 2012. For sure it trounced stocks. At some point the author is correct and rates will go up, Many experts have been warning about this for several years, and have been wrong for several years.

  • Report this Comment On February 12, 2013, at 2:45 AM, dgmennie wrote:

    Your chart of treasury yields (in this article) shows an extremely conservative (zero risk) fixed-income investment, paying respectable returns from 1970 to about 2005 or so. (The interest spike to 15% around 1980 was a short-lived fluke inspired by inflation.) Over this same 35-year period I'll wager there is NO comparison with the gyrations of stock prices and stock dividends -- even for "blue chip" securities! So why bash bonds?

    Yes, decent-quality fixed-income securites have paid out very little for the past few years, while stocks have zoomed up. But that's only true if you start measuring today's stock prices against those at the bottom of the last crash around 2008-2009. All that has happend recently is the market AS A WHOLE (during the past few weeks) is now valued about the same as it was in 2007 (near 14,000 -- just before it went over the cliff). So where is the big gain for MOST investors whos IRAs bombed back then and did not have additional funds or the nerve to buy more stocks during (or just after) the last crash? And who knew (then) that the bottom was at hand, not just another rung on the way further down? Fact: these folks lost a bundle, understand they have no way to "time" the market, and have decided to stay out.

    The real evil afoot today is our US Government rigging interest rates at artificially low levels as a favor to those who continue to squawk that they can't do business without endless amounts of cheap money. Yet the average person is still expected to pay upwards of 25% interest on credit cards or put huge amounts down before they can get a home mortgage. In essence the greedy, "connected" beasts of our economic system are having their cake and eating it too. Meanwhile, conservative savers, retirees, and others who need and certainly deserve a REASONABLE and SAFE way to earn a modest interest income of 5% to 7% have been hung out to dry.

    Please don't tell me that buying or selling options is the way to stock market riches. This is a casino game that only a few pros understand well enough to play successfully. This DOES NOT include the average small investor who requires steady, worry-free income from his/her portfolio every month.

  • Report this Comment On February 12, 2013, at 7:37 AM, TMFMorgan wrote:

    Thanks for the comments,

    <<The writer mentions the loss from 1940 to 1979, but fails to mention what the bonds returned from 1980 to 2012. >>

    Bonds did very well from 1980 to 2012. I showed the 1940-1979 example because today's interest rates are at 1940s levels. If interest rates were at 15% as they were in 1980, investing in bonds would be an entirely different story.

    Re: Japan, there are two points. One, Japanese bonds have not been a good investment over the last 20 years. They haven't exploded, but you haven't made much money in real terms. If that's the example bondholders wish to use as their best-case scenario, so be it. Just know that you're in a heads-I-don't-win, tails-I-lose-big investment.

    Also, I have no idea when interest rates might rise. Next week, five years, 10 years, I have no idea. But you don't need to predict when interest rates will rise to know bonds aren't a good investment when they yield less than the rate of inflation.

    -Morgan

  • Report this Comment On February 12, 2013, at 7:48 AM, MrFinance223 wrote:

    There is no question that bond prices will fall once interest rates rise - the only question is when it will happen. Ben says we are safe for a few years.

    I need bonds in my potrtfolio for diversification and stability. However, I plan to watch this very closely and make a fast exit before the bottom falls out. Timing is everything!! Until then, I will play it consertative by investing only in TIPS.

  • Report this Comment On February 12, 2013, at 9:15 AM, TMFGortok wrote:

    This is a great article Morgan. One thing for everyone to consider is that the rate of inflation that is reported is somewhat lower than the real rate of inflation that people experience every day of their lives. While officially it may only be 2.5%, in real terms it's much more than that. The CPI is the Football, and the BLS is Lucy. Don't be Charlie Brown.

  • Report this Comment On February 12, 2013, at 9:21 AM, TMFMorgan wrote:

    <<One thing for everyone to consider is that the rate of inflation that is reported is somewhat lower than the real rate of inflation that people experience every day of their lives>>

    It depends who those "people" are. Everyone has their own rate of inflation. I don't drive much, so gas prices are irrelevant to me -- gas prices doubling would have almost no impact on my budget. 10 years ago I had 100-mile daily commute, so it was the other way around. It's different for everyone.

  • Report this Comment On February 12, 2013, at 10:27 AM, t0bes wrote:

    My employer only has limited options for me to save in. I'm currently in a target date fund that's putting ~15% into bonds. Are you suggesting avoiding bonds completely Morgan?

  • Report this Comment On February 12, 2013, at 10:30 AM, TMFMorgan wrote:

    ^ It depends on 1) What bonds you're investing in and 2) How long before you need to access your money.

  • Report this Comment On February 12, 2013, at 11:30 AM, steelerfan22 wrote:

    Taking into full consideration the past stock market crashes can you suggest a strategy other than a distribution between bonds and stocks that would offer us protection in a stock only environment. Please be specific if you can. My current opinion is that to protect against the risk you should not be fully invested in any one investment source.

  • Report this Comment On February 12, 2013, at 11:39 AM, thunderboltnova wrote:

    Oh no I have to go into stocks now. I bailed when the Dow was at 7,000. Now you tell us.

  • Report this Comment On February 12, 2013, at 12:28 PM, digitalroom wrote:

    stocks get destroyed just as much as bonds. it all depends on what particular stocks u own and how much u paid for them. "You have never lost money in stocks over any 20-year period?" You can lose money investing in either stocks or bonds over any period of time. It all depends on the style of investing that you're doing. So that statement is not all that accurate.

  • Report this Comment On February 12, 2013, at 5:19 PM, JadedFoolalex wrote:

    xetn:

    When the bond bubble bursts, watch the stock markets, REITs, hedge funds and other alternative investment vehicles explode!

  • Report this Comment On February 12, 2013, at 5:26 PM, JadedFoolalex wrote:

    digitalroom:

    Stocks representing great, well run companies did better than all other investments from the 1850s to today! Don't believe me, look at an Andex chart!

  • Report this Comment On February 12, 2013, at 10:29 PM, SkepikI wrote:

    Ah Morgan, the Cassandra of your time. Not to be believed until the massive Rabbit Punch of declining values races to more than it has in the past 3 weeks. Note to "Bond Investors" if you buy lots of individual Bonds, unless you are unusually lucky or unusually good (or both) sooner or later you will run into a bond default. Just ask GM bond holders of say 10 years ago...... they didn't even maintain their priority in the cash crunch thanks to US Treasury flexing their muscle to set aside bankruptcy law... the world has seen the behavior of artificial investment bubbles up close and personal for about a decade in multiple different assets... Caveat Emptor- in English "watch out for the Rabbit Punch"

  • Report this Comment On February 13, 2013, at 12:48 AM, crca99 wrote:

    Thank you for being so concrete in your examples. The bond allocation in my employer's retirement account will stay instead in cash at 2.3%. Whew, that's a decision that took six weeks to make.

  • Report this Comment On February 13, 2013, at 7:59 PM, Cruiser55N wrote:

    There can be no net selling in the market as a whole. Somebody must hold all the paper all the way down. Given the oceans of debt floating around out there that means massive wealth destruction in many portfolios.

  • Report this Comment On February 14, 2013, at 2:19 PM, slpmn wrote:

    Unless the math has changed significantly in the years since I actually studied this stuff, if one cares at all about risk (volatility), then one's portfolio should have some bonds in it. Not a lot, certainly not a majority, but some. It reduces the volatility more than it reduces return, so the "risk adjusted" return is greater.

    Second, "danger" is relative. A catastrophe in the bond market is a 10% annual drop, in the stock market, it would be more like 30-40%. 1994 is considered a historically bad year for bonds, but when it was all said and done - not really a big deal, particularly not for individual investors who weren't in odd derivitive-based products. Contrast that with the (sometimes multi-year) stock market crashes we've seen since then, and the lasting impact on personal wealth is not at all comparable.

    Not only that, as some have noted, with bonds (excluding the high yield variety) you may see some volatilty in market value during it's term, but there is a very high probability that you will get 100% of your principal back at the end. With stocks, whether or not you recover your principal at some point is far more uncertain.

    It's stuff like this that reminds me the Fool, as great a resource as it can be, is dedicated to stock investing, not necessarily personal financial planning or even diversified investment portfolio building.

  • Report this Comment On February 14, 2013, at 2:22 PM, TMFMorgan wrote:

    << It reduces the volatility more than it reduces return, so the "risk adjusted" return is greater.>>

    Ask someone who owned bonds in 1994 how much it reduced volatility in their portfolio.

  • Report this Comment On February 14, 2013, at 2:25 PM, TMFMorgan wrote:

    <<Unless the math has changed significantly in the years since I actually studied this stuff,>>

    I think you answered your question there. The math on bonds is far different when yields are at all-time lows and less than the rate of inflation than it is during normal times.

  • Report this Comment On February 14, 2013, at 2:32 PM, Borbality wrote:

    All I know is that when the US credit got downgraded, bonds soared!!

    Anyway, I had some of my IRA in PIMCO Total Return but have been selling as of late as I feel better with cash than the great unknown that is the bond market.

    however, I would like to see some stories that differentiate between corporate bonds and treasuries. The bond market is strange and mysterious to me.

  • Report this Comment On February 15, 2013, at 10:13 AM, slpmn wrote:

    Look at the data on the Lehman bond index's performance in 1994. I think you'll be quite underwhelmed by the "crash".

    Second, the math I'm referring to is portfolio math, and the relevant figures are the correlations between assets in the portfolo. As long as the correlations between bonds and stocks are low, having some bonds helps reduce volatility without giving up too much return.

    I would acknowledge the real danger of holding too much in bonds, which is what you give up in long term return. Rates are historically low, and can't really go much lower, but that doesn't mean there is an impending increase on the horizon. We could easily bounce along at this level for another decade. Or not. Who knows. But every investor should own some bonds. I think you'll be surprised at the satisfaction you get during those inevitable months when the stock market is tanking, and you see that at least one small chunk of your portfolio is actually holding up, just chugging along like nothing is happening.

  • Report this Comment On February 15, 2013, at 10:20 AM, TMFMorgan wrote:

    << I think you'll be quite underwhelmed by the "crash".>>

    Here's a headline from 1994:

    "In a year of low inflation, bondholders have suffered more than $1 trillion in losses."

    http://money.cnn.com/magazines/fortune/fortune_archive/1994/...

  • Report this Comment On February 15, 2013, at 3:53 PM, asdfk123 wrote:

    << Ask someone who owned bonds in 1994 how much it reduced volatility in their portfolio. >>

    I think you might be missing the point, Morgan. I think what slpmn is trying to say is that risk adjusted return should be measured over decades and not sampled year-over-year, as you are implying with the 1994 crash.

    Great article, I think you’ve done a great job of illustrating the risks of medium/long-term bonds at the present.

  • Report this Comment On February 15, 2013, at 3:59 PM, MajorBob04 wrote:

    Great article. But I happen to agree that having some money invested in bonds or bond funds make sense, especially if it turns out that the stock market crashes sooner rather than later, and interest rates remain low for another 10+ years.

    I think it would help to provide some guidance on what the ratio in various types of portfolios should be.

    Maybe a good topic for a future article?

  • Report this Comment On February 15, 2013, at 4:42 PM, NoOracleHere wrote:

    Good article, Morgan. When the government policy is to manipulate interest rates, it's easy to forget that bonds are a market, subject to free market dynamics. We might think that the government can do anything it wants with interest rates, but it can't, really. Interest rates are low because when the treasury offers bonds at those rates, people buy them. If people (and foreign governments) stopped buying them, then they would have to offer higher rates, either that or the Fed would have to buy them. But that is inflationary, and could not go on for too long. If the treasury didn't sell bonds, then it would have to stop paying the bills. So once the general public starts doing math again, and people figure out what inflation is costing them, I think you'll see some of those darker scenarios start to play out. I don't relish it, but it almost certainly will happen. Either that, or people will be content to buy bonds and lose money slowly, -- and at times less slowly.

  • Report this Comment On February 15, 2013, at 4:53 PM, NoOracleHere wrote:

    Morgan, here's another thought. I myself have a cash allocation target. I know I lose money slowly holding cash (rate of inflation) but I also use cash as "dry powder", and in that regard, as an asset class it has its own intrinsic value. When finding effective ways of holding such an asset "for a rainy day", so to speak, bonds do make sense, in that even with a negative real return, they can perhaps be more effective than cash. The real danger, I think, is tying your money up in long term bonds at these low rates, where the bond loses its investment value as a store of "dry powder". Then it's really a losing game.

  • Report this Comment On February 16, 2013, at 9:59 AM, jahcolony wrote:

    I'm new at this, so be kind. Are tax free muni's in the same boat as treasuries? will the "bubble" burst for them? they have been pretty steady for the last couple of years

  • Report this Comment On February 16, 2013, at 4:06 PM, mikecart1 wrote:

    My bonds continue to pay me a nice amount of cash monthly. People have been warning bond holders for years of this so-called 'bubble'. IMO, if the bond bubble bursts, there will be far bigger things to worry about than temporary bond value losses...

  • Report this Comment On February 16, 2013, at 8:09 PM, ChrisBern wrote:

    The biggest mistake most analysts make with regards to bond is that they compare them to stocks, e.g. a common refrain is "stocks are better than bonds".

    The problem with that logic is when they are BOTH overpriced and dangerous, then stocks being RELATIVELY better than bonds doesn't really mean a whole lot. Even a balanced portfolio of 60% stocks and 40% bonds is likely to get whacked and whacked hard over the next 5-10 years.

    They may be more obscure or difficult to invest in, but there are other investments besides stocks and bonds, and I'd recommend that people consider those alternative investments before jumping into stocks just because they're "less lethal" than bonds.

  • Report this Comment On February 18, 2013, at 4:39 AM, edithlutz wrote:

    What I miss in your discussion is the loss through inflation! With an average inflation of 2% per year you easily can caluclate what you'll get back of 100USD after 5 years.

    That's not an emotional thing, but a fact.

    Investing into a bond fund should at least put that problem onto the desk of the fund manager whom I would expect to handle the interest and inflation issue accordingly. And of course I would choose a distributing fund and use the interst gained for a new investment. Probably a savings plan stock fund.

    The next point - there is a difference between government bonds, coporate bonds, international bonds with local currencies or currency hedges. You cannot compare all these!

    Did anybody of you ever consider an inflation linked bond / bond fund? Then at least the inflation thread should be covered.

  • Report this Comment On February 18, 2013, at 4:44 AM, edithlutz wrote:

    Oh, just have seen that Morgan already had posted somthing regarding the inflation.

  • Report this Comment On February 20, 2013, at 4:09 PM, awarenessrus wrote:

    Morgan,

    I always enjoy reading your stuff. I agree with many here who have essentially said: we need some bonds for diversification of risk.

    Could you do a follow-up article on:

    1. What percentage of the portfolio should be in bonds given the current situation and the future possible scenarios; and

    2. Where should new money (that would have normally gone to bonds) be now to keep diversification but avoid what may be coming? e.g. TIPS? Elsewhere?

  • Report this Comment On February 25, 2013, at 2:18 PM, fool3090 wrote:

    I'd also like to see what, if any, place in a portfolio of bond ETFs, specifically T-bill ETFs.

  • Report this Comment On February 26, 2013, at 2:55 PM, Sturmudgeon wrote:

    Morgan: Thanks for the article, and thanks for the comments submitted...

    <<One thing for everyone to consider is that the rate of inflation that is reported is somewhat lower than the real rate of inflation that people experience every day of their lives>>

    Altho' my/our costs for the things we buy weekly/monthly are most probably a bit different than the 'average' family's costs (we live quite frugally, yet comfortably), we have seen increases from 10-33% over the past 6 months... so I do not believe for a moment that 'inflation' is anywhere near 2-3%!

    A recent book I read had a main theme on "perception management", and certainly had me relate to what is coming from practically ALL government 'stats'/numbers... pretty much total B...S...

  • Report this Comment On February 27, 2013, at 2:02 AM, MARKETSURFER wrote:

    Treasury Inflation Protected Securities (TIPS) seem to be a more reasonable alternative in bond investments as they offer a nice dividend return that is State tax free, the bonds are fully backed by the federal government for their face value and though a mutual fund for TIPS can go down, once again,

    the underlying bonds purchased by the mutual fund are fully backed by the federal government. In the event that inflation increases the return on the

    Treasury Inflation Protected Securities also increases.

  • Report this Comment On September 19, 2013, at 2:46 PM, joebobjones1 wrote:

    Everybody keeps saying "if you have more than ten years until retirement" and "stocks haven't ever lost money in any 20 year period", blah blah blah. Well guess what? Millions of Baby Boomers that are 55 to 60 years old don't have that much time! What do they do? Stocks are risky over the short term, and now bonds are poised for a multi-year bear market. Now what?

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