Today, The Big Risk Is in Bonds
April 26, 2013

Today, The Big Risk Is in Bonds

Few investment research reports become turning point documents. But I have kept one for nearly 30 years because it was so important and so powerful. It still says a lot to us today, but in reverse.

The report, “The Investment Magic of ‘Zero’ Bonds,” came from the Leuthold Group in late 1983. The Leuthold Group is in Minneapolis. Its prime mover is Steven Leuthold, a researcher who has often identified himself as “an equities guy.” The existence of bonds was acknowledged, but only as distant competitors for stocks.

That’s what made this report so compelling. In it’s 61 pages of comment, tables and data it shows how it would be virtually impossible for common stocks to beat the guaranteed 12 percent return zero-coupon Treasury obligations offered at that time.

 (A zero-coupon bond is a bond that is issued at a discounted price. Its value grows to its maturity value. Since it has no coupons, you can be certain of the compound annual return if you hold to maturity.)

Back in 1983, even with interest rates below the record rates of 1981, you could buy a zero-coupon Treasury maturing in 20 years— 2003— for $1,051 with the promise it would mature at $9,500. That’s a compound annual return of 11.65 percent. The argument in the report was that interest rates were so high that investors were virtually invulnerable. Only hyperinflation could defeat bonds with such high yields. Whether interest rates went up or down, stocks would have a very hard time producing as high a return.

Today we know: The report was right on the money.

It showed, for instance, that a decline in interest rates would cause the value of the bonds to soar. If the interest rate on a 20-year Zero declined from 12 percent to 10 percent in 5 years the annualized return on the bond would be 18 percent. In fact, interest rates fell more, so the return if you sold before maturity was still higher. Basically, buying bonds was a no-brainer, a very low risk deal.

But that was then.

Now the situation is nearly the opposite. While people are still worried about government deficits, rising federal debt, and the possibility of hyperinflation, yields on Treasury obligations are approaching record low levels. Worse, in all short-term maturities the yield is lower than the rate of inflation. Today, for instance, the yield on a 10-year Treasury is 1.70 percent— about the same as the trailing rate of inflation.

The risk that interest rates will rise is now greater than the opportunity of a continued decline. More important, the losses could be significant.

How significant? Well, let’s see what investors would pay for that 10-year Treasury if interest rates rose by different amounts. If the market demanded a 2.7 percent yield— an increase of only 1 percentage point— the value of that $1,000 Treasury would fall to $912.87. That’s a loss of $87.13. So you could lose 8.7 percent of your money. Viewed another way, you’d lose an amount equal to about 5 years of interest income.

If interest rates rose to 5 percent, a yield closer to historical norms, the value of the same bond would decline to $742.78. That’s a loss of 25.7 percent, an amount that would feel like a stock market crash.

Shorter-term securities would lose less and longer-term securities would lose more, but the basic principle remains the same: In today’s fixed income market we are risking a large amount of principal to capture a smidgeon of yield.

Will interest rates rise in the future? Many analysts, but not all, think so. Everyone with savings wishes that interest rates would rise and just about everyone would agree that interest rates are more likely to rise than to fall. Just because everyone thinks something should happen doesn’t mean that it will. (For a contrary view, one that indicates we may be stuck with low interest rates for many years, read this interview with economist Lacy Hunt.)

Bottom line: If you’ve been obsessing over yield and reaching for it in fixed income securities, this may be a good time to take a close look at where the exits are.

Sidebar:  How To Estimate The Risk In Your Bond Fund Investment.

Want to get some idea of how much money you could lose if interest rates rise? You can do it without being a bond expert. First, go to the Morningstar website and look up your fund. Find its average maturity and current yield. Then go to an online bond value calculator and enter the values for your fund and test against higher interest rates.

Here’s an example. On the Morningstar website the Vanguard Total Bond Market ETF (ticker BND) is listed as having a current yield of 2.64 percent and an average maturity of 7.1 years. The calculator tells us that an increase in interest rates up to 3.64 percent would cause a loss of about $66 or 6.6 percent. That’s about 2.5 years of current interest income.

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