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

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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