When Bonds Are Broken

Posted: Apr 07, 2009 12:01 AM
When Bonds Are Broken

Body text: It's a sad fact that some consumers do stupid things when they are scared. They sell low and buy high. They abandon the stock market altogether and park all their cash in savings accounts. Or they load up on bonds.

A lot of people think bonds are a safe, quiet place to ride out investment turmoil. But if in this flight to safety you've loaded up your portfolio with a bunch of bonds (regardless of whether they are government, municipal or corporate), I'm worried for you.

Bonds are subject to two prominent risks that can expose investors to substantial losses. If you own bonds or are thinking about buying them, be aware of these risks.

The first is interest-rate risk. Interest rates and bond prices have an inverse relationship: When one rises, the other falls. This is not conjecture; it's mathematical fact.

In normal times investors debate whether interest rates will rise or fall. But these days there is no debate, because the Federal Reserve has set its interest-rate target at zero. Rates cannot go into negative territory, so they only have one direction to go: up.

It may take months or even years for that to happen, but eventually rates will rise. When that happens, bond values will drop.

Why? You can thank the simple law of supply and demand. Say the government issues a 1 percent bond and you buy it. Later, say that the government raises rates to 2 percent and you decide to sell your bond. Would an investor rather buy your 1 percent bond or a new one that pays 2 percent?

Clearly, the 2 percent bond is the better choice. In order to find a buyer for your bond, then, you'll have to offer a higher interest rate. Oops -- you can't do that! You can lower your price, though. By selling the bond for less than its face value, the buyer is compensated for your bond's lower interest rate.

How much lower? Let's look at the math. Say you buy a $10,000, 10-year AAA-rated bond paying 3.9 percent. If rates rise 1 percent and you try to sell your bond, you'd lose 7 percent ($700) of your money. If interest rates go up 2 percent, you lose 14 percent, or $1,400.

Interest-rate risk isn't the only risk. There's also credit risk. As companies experience financial difficulties, their bond ratings get downgraded.

If an AAA bond falls to AA, the bond's value drops 8 percent.

And watch out if interest rates rise and bond ratings decline at the same time. If your AAA bond falls to AA at the same time that interest rates rise 1 percent, you'd lose 15 percent of your money. If interest rates rise to 3 percent and the bond falls to DDD, you lose 44 percent of your money. And in a truly terrible, but possible scenario, if interest rates rise to 3 percent while a bond falls to junk value (BB), you would face a whopping 83 percent loss.

Fortunately, there are several ways you can reduce these risks. First, pay attention to a bond's duration. That term refers to the life of the bond. (It's not the same as maturity, which is the date the issuer is to return your principal; duration refers to the average life of a bond, which is usually shorter than its maturity. Ginnie Maes, for example, have a 30-year maturity date, but typically have a duration of only seven years because people refinance, default or sell their homes -- thus paying off their mortgages -- long before the loan is due to mature.)

Long-term bonds are more sensitive to interest rates than short-term bonds. Therefore, you can cut your interest-rate risk by limiting your bonds to those that have durations of seven years or less -- and the shorter the duration, the less risk.

Second, limit your bonds to those that are unlikely to experience cuts in their credit rating. Ideally, this means buying bonds issued by and fully backed by the U.S. government. Municipal bonds and corporate bonds can be downgraded and are therefore riskier. (Interestingly, some will argue that the safest bonds are those that have already been downgraded: Junk bonds are worth buying because their ratings have nowhere to go but up.)

Third, and more importantly, don't overweight your portfolio with bonds. Maintain a meaningful allocation to stocks, real estate, natural resources, precious metals, and oil and gas -- assets that are not (or not directly) affected by interest rates and credit ratings. Diversification helps when facing the challenges of a financial marketplace in turmoil.

Imagine the poor soul who invested his money in stocks in 2008 -- and watched the S&P 500 fall 38 percent. Determined not to let that happen again, and desperate to avoid further losses in the stock market, he moves his money to bonds -- and unwittingly sets himself up to lose another 40 percent when interest rates rise.

Don't let that happen to you. If the stock market's recent performance has tempted you to sell stocks low, you might buy bonds high without knowing it -- and it's always what you don't know that hurts you.

That's why you should let your portfolio be managed by investment professionals who know what they're doing.