People often buy bonds seeking safety or risk reduction. There is an assumption here that needs exploring – because right now long-term bonds are one of the riskiest assets in the market.
First, a little refresher on long-term bonds (and I will assume we are talking about 30-year bonds since we are talking about bonds, not notes or bills).
If you buy $100,000 of U.S. Treasury bonds today, and if interest rates are 3%, you will get $3,000 per year for 30 years (totaling $90,000 in interest), plus get your $100,000 back in year 30. Put in $100,000 today, and you end up with a total of $190,000 returned at year 30.
If you are an insurance company or government and have some fixed liability of $190,000 that you must pay in 30 years, this works fine: put up $100,000 today and you have immunized your future fixed liability. But few of us have those sorts of long-term, fixed liabilities. Instead, we invest to maximize future wealth without too much risk. We treat bonds as an investment like stocks.
Similar to any investment, problems arise in the future, whether it be unknowable future returns (as with stocks) or unexpected timing needs (as with bonds). To see this, suppose you had put $100,000 into bonds for “safety” at 3% yesterday. Imagine if next year you lose your job and need to move to a pricier city to work. To buy a house that’s more expensive than your current house, you need to come up with $100,000 in cash after selling your current home. If interest rates stay the same, you are in luck – because you have $100,000 in bonds squirreled away for just such a rainy-day scenario.
But what if rates went up in the meantime? What if they went from 3% to 5% along the way?
Go to any reference on bonds and you will learn that a 30-year bond loses about 15% of its value when rates rise 1%. This ratio between rates and price is called duration. Duration is roughly half the life of a bond: a 30-year bond has a duration of about 15, so a 1% increase in rates reduces the bond’s value by roughly 15%. Thus, a 2% rise in rates causes something like a 30% drop. If you try to sell those “safe” bonds to get $100,000 back, you have a surprise: you can’t sell those bonds for much more than $70,000. Whoops. Given the timing, those bonds were a very risky asset.
Bond risk is hard for people to understand because it is backwards from stocks. With stocks, we don’t know the future price or dividends; prices adjust in the future to reflect business results. Bonds are the reverse. With bonds, we know all the future payments, so prices must adjust now to reflect changes in current interest rates.
Here is another way to see this. Suppose you bought $100,000 of bonds yielding 3% on a Monday and you held them to maturity. After getting the $90,000 in interest payments and the return of principal in year 30, your bond account has (roughly) a $190,000 balance. So far so good.
Now let’s think harder about what happens if the day after you invested rates rose from 3% to 5%.
Had you waited until Wednesday – after rates rose – and bought $100,000 of bonds yielding 5%, your account would have ended up with $250,000 at the end ($5,000 of annual interest payments for 30 years, plus the return of principal) – a difference in final outcome of about 30% of total wealth (or $60,000). Before we looked at how early liquidation could hurt you. Now we see that the risk of future wealth could also vary by about 30%, even if you hold to maturity over the full 30 years. Once again this is a very large risk: timing of investment makes a 30% difference.
Of course, we won’t see bond rates move 2% overnight. But 1% or 2% changes are well within normal experience. Today, some European government bonds are at negative rates. But in 1980, the coupons of U.S. 30-year bonds reached a high of 14.49%.[2] In fact, we believe the great “bull market” in bonds of the past 30 years has no thundering bull behind it. It is simply the result of falling inflation, and thus dropping interest rates, over that 30 years.
In our experience, a common error by investors is to think that bonds have no risk, so long as they wait the full 30 years. But, as you can see, the price of long-term bonds you buy today could drop from a 2% move in interest rates. And holding to maturity is no panacea since the future wealth you get could vary wildly depending on when you invest.
Why does this get missed so often? I think you can blame it on Modern Portfolio Theory (MPT) and the Capital Asset Pricing Model (CAPM). MPT and CAPM were designed to try to explain stock prices in the 1950s and early 1960s, the era of slide rules. To do that, they needed a hypothetical investment called the “risk-free” asset.
This was a poor choice of words. What is meant by the asset being “risk-free” is the technical quality that it has no correlation with the stock market. In this context, “risk-free” does not mean that credit quality is high, prices are stable, or payments are fixed. So, what could qualify as “risk-free”? Cash in a savings account for sure. But among other things that might qualify as “risk-free” are short-term junk bonds with enough yield to offset their credit risk, gold, fine art, or even rare comic books.
From sloppy language that gets used in MPT and CAPM orthodoxy everyone has the impression that government bonds are a risk-free asset when it comes to investing. They are not. What they are is fixed income assets because we know the schedule of payments upfront.
But from an investment perspective, bonds can be anything but risk-free. In fact, they can be a very, very risky part of a portfolio – even if held to maturity.
Opinions expressed are current opinions as of the date appearing in this material only. While the data contained herein has been prepared from information that the author believes to be reliable, the author does not warrant the accuracy or completeness of such information. This communication is for informational purposes only. This is not intended as nor is it an offer, or solicitation of any offer to buy or sell any security, investment or product.