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Devil’s Advocate: Bonds Are Not Safe
Posted By Jim On 08/07/2012 @ 7:15 am In Devil's Advocate | 4 Comments
Read enough investing advice and one of the classic “rules of thumb” is that your investments should be “diversified.” It’s hard to argue against the advice that you shouldn’t have all of your investing eggs in one basket because it’s usually sound advice. It breaks down when you start wondering which baskets you should be putting your eggs in! Should you put it in five baskets? Evenly? More in one or the other? That’s when the experts say you should follow something like the 120 Minus Your Age  rule. That rule stats that you should subtract your age from 120 and put that percentage of your investments in stocks. Put the rest in bonds.
In essence, it’s saying that stocks are risky and bonds are safe. Bonds are usually safer than stocks because they aren’t subjected to the same price fluctuations, in part because the market for bonds isn’t as large or as liquid as stocks. It’s still pretty big but it’s not like stocks. You don’t have people talking about bonds as often as they talk about stocks because bonds are, well, kind of boring. They aren’t, however, 100% safe.
The basic idea behind a bond is that it’s a loan. Companies and municipalities issue bonds to help pay for things. You buy a bond, you get a coupon each month or quarter or year, and when the bond matures, you get your money back. Sometimes there are zero coupon bonds where you get no interest but you buy the bond at a discount to face value. The bond is backed by the entity that issued it. The interest you earn off that bond is based on the credit worthiness of that entity. The riskier the entity, the higher the interest rate. Sounds pretty safe right?
Here’s where it gets tricky… bonds can be sold on the market. That means their value can fluctuate depending on demand for that particular bond and for bonds in general. The underlying value of the bond, the face value, can’t and won’t change but to reclaim that you will have to wait until maturity. The interest it pays won’t change either. The terms are set until maturity. The tricky part is that the bond’s market price can change and that can have an impact on things like a mutual fund for bonds. Your value will change and the manager can decide to sell the bond or do any number of things besides wait until maturity.
Many municipalities, and even more companies, can default on their bonds. Can you guess what the rate of default is? If you thought it was 0% then you’d probably be surprised to learn it was 5.5% in 2010 and 2011 . It’s much higher than the 2.7% for the previous thirty-nine years, according to Moody’s.
You can avoid many of the default if you stick with general obligation bonds (health care and housing bonds accounting for 73% of defaults) but in the end, you have to really do your homework to avoid buying municipal bonds from the wrong municipalities!
The biggest risk is ultimately interest rate risk. When interest rates go up, bond values go down. When interest rates go down, bond values go up. That’s because a bond will pay an unchanging amount each period and how much that payment is worth will depend on the prevailing interest rates. Let’s say you can get a 10-Year Treasury Note  for 1.61%. That’s 1.61% for absolutely no risk whatsoever (technically not “absolutely no risk” but you know what I mean). If that rates goes up, if the risk free rate goes up to 2%, then anything risky is now worth less than before because you’re now getting less yield for the same amount of risk.
So let’s say you have a bond that pays out 3% but you take a little bit of risk that the bond will default. You paid some amount when the 10 Year T-Note was at 1.61%. If the 10 Year T-Note now yields 2% and you want to sell that bond, you won’t be able to get the same amount you paid for it. You paid to get 1.39% of extra yield and now, with the same amount of risk, you only get 1% of extra yield. The difference has to come from somewhere and that’s in the value of the bond. If you hold it until maturity, you get the face value regardless of the market value. If you don’t, then you will have paid for the interest rate going up.
The interest rate is pretty low right now, so the risk isn’t whether rates will go up… but when.
These are just a few of risks with bonds but I think it illustrates the bigger point that bonds are, in general, safer than stocks but by no means 100% safe.
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 120 Minus Your Age: http://www.bargaineering.com/articles/stock-allocation-rule-120-minus-age.html
 5.5% in 2010 and 2011: http://www.bloomberg.com/news/2012-03-07/u-s-municipal-bond-defaults-rose-in-past-two-years-moody-s-report-says.html
 10-Year Treasury Note: http://www.treasury.gov/resource-center/data-chart-center/interest-rates/pages/textview.aspx?data=yield
Thank you for reading!