When times get tough, investors always look for safe investments. Yet while bonds have a reputation for being conservative, you shouldn't see them as a no-lose proposition.
The easy way to diversify
When assembling a diversified portfolio, many investors believe they must decide between two types of assets: stocks and bonds. They see stocks as the risky choice, subject to the whims of the overall market. In contrast, bonds seem secure and solid, apt to hold up well even when the stock market is plummeting.
Certainly, bonds have been the place to be so far this year, while stocks have faltered. But drawing the conclusion that bonds are always safer than stocks is dangerously simplistic. Bond funds have plenty of risk, and if you're not prepared for what could happen to your bond investments, you could be in for a nasty shock.
The many risks of bonds
Everything's been going right for bonds lately, but when the tide turns, plenty of things can go wrong.
The biggest risk for bonds comes when interest rates rise. Whether you own Treasuries or any other kind of bond, higher rates hurt the value the existing bonds that funds own. The iShares Barclays 20+ Year Treasury ETF (NYSE: TLT ) , which focuses on long-term Treasury bonds, is highly vulnerable to the adverse impact of rate hikes. But even the short-term iShares Barclays 1-3 Year Treasury (NYSE: SHY ) could take a big hit in a rising-rate environment, especially with its current yield at just 0.54%.
A related risk comes from potential inflation. When you buy traditional bond funds that invest in fixed-rate bonds, you're hoping that low inflation will eat away as little of the purchasing power of your investment as possible. If you're interested in protecting against inflation, iShares Barclays TIPS Bond (NYSE: TIP ) and its international equivalent, SPDR DB International Government Inflation Protected Bond (NYSE: WIP ) , hold bonds that are indexed to inflation. But bear in mind that even these funds aren't protected from rate risk entirely -- just from inflation in particular.
Another thing bond fund investors have to deal with is reinvestment risk. Many CD investors are running into a similar problem now, as they try in vain to replace maturing CDs that paid 5% or 6%. As bond funds see holdings mature or sell existing bonds, current low rates mean that the new bonds they replace those holdings with bear less interest. That forces the yield on bond funds to fall slowly but surely over time without any corresponding rise in their share price.
Default: Not just for junk anymore
Finally, default risk remains a huge concern for investors in corporate and municipal bond funds right now. Often, investors figure that if they steer clear of high-yield "junk" bond funds, their potential for default is limited.
But the financial crisis in 2008 proved that even investment-grade debt, such as that issued by General Electric (NYSE: GE ) and Citigroup (NYSE: C ) , can potentially raise default concerns under the right conditions, pushing the prices of investment-grade bond funds down sharply. More recently, BP (NYSE: BP ) debt has fallen in price as investors fear that the billions necessary to clean up and reimburse victims of the Gulf oil spill will stretch the company's finances to the breaking point.
Moreover, with state and local governments strapped for cash, many communities seem poised to default on municipal bonds they've issued. Although many such bond issues are insured, that may not be enough to protect bond funds entirely from potential liability.
Weigh risk and reward
It's certainly true that bond funds have been the saving grace for many investors, especially conservative retirees and others looking more to preserve their capital than to see it grow substantially. For many, keeping a substantial portion of your assets in bond funds still makes sense, even at low rates.
But if you have the time and discipline to take on a higher allocation to stocks in your portfolio, you should take a hard look at your bond fund exposure. With many interest rates at historic lows, bond fund shareholders have the opportunity to sell at extremely high prices. That opportunity might not last long.
There's plenty of risk to go around. Find out why Nate Weisshaar thinks China is poised on the precipice of an impending collapse.