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Friday, March 27, 2009

Bonds aren't as safe as they may seem

When stock markets tank, most people think, "boy do I wish I owned bonds."

Let me make this clear--bonds are NOT riskless. Although people perceive them as riskless, they are not! Bonds face risks from default and inflation.

Many people wish they owned bonds because U.S. Treasury bonds have done so well over the last year and a half. That doesn't mean all bonds have done well. Junk bonds, corporate bonds, investment grade corporate bonds, municipal bonds, mortgage backed bonds, etc. have all been decimated.

To have done well with bonds during this downturn, you'd have needed to be prescient enough to know exactly which bonds to buy and no others. Very few people are that good at forecasting beforehand. Everyone is afterward--but those are profits you can't eat.

So, what are the risks for bonds. The first risk is the same as for stocks--what you buy can become worthless. Government bonds rarely default, but rarely is not never. The second risk is inflation. Government bonds are very vulnerable to inflation risk (the exception being inflation protected bonds, but even they face inflation risk if the consumer price index differs from your cost of living increases).

How can a bond become worthless? A bond has a senior claim on a business's assets. That means bondholders get paid before equity holders. But, that claim comes after customers and after the tax man. If a company goes bankrupt, bond holders can still be wiped out. They get paid before equity holders based on what's left, but that doesn't mean they will get paid back in full, and it doesn't mean they will get paid back with certainty.

The bigger threat to bondholders is inflation. And, here, I believe stockholders are actually better off than bondholders.

Suppose you buy a 3% bond and inflation goes up. If you own a short term bond, your impact is smaller than if you own a long term bond. A short term bond can be rolled over into a higher yields as inflation goes up. A long term bond doesn't have this luxury.

How much of an impact am I talking about? Pretty big. Suppose inflation goes up by 3% more than the market expects: the value of a 10 year bond would decline by around 20% (all things equal). A 30 year bond would decline by almost 40%! If inflation went up 6% more than people expected, then a 10 year bond would decline by 40% and a 30 year bond would decline by over 60%! If you believe bonds can't go down like stocks, think again!

The price declines I referred to above would happen quickly, but you'd still get back your full principal at maturity, right? The problem is that those dollars will be worth a lot less than they are now. Whether you sold right away or held to maturity, higher than expected inflation will hammer long term bond holders.

That's true for government bonds as much as any other bond. In fact, I believe government bonds are much more risky than usual now. Almost every other type of bond is trading at record high relative yields, so they are safer from inflation risk than government bonds that are at record low yields. Government bonds are extremely unlikely to default, but the dollars you'd receive may not be worth much.

Most people seem to under-estimate the risks of bonds. Default risk and inflation risk make them risky, whether people recognize it or not. Talk to anyone who owned bonds in the 1970's, and they'll tell you what owning bonds felt like in an inflationary and recessionary environment.

Stocks may have a lower priority claim on a business's assets, but they do adapt to inflation better. The revenues and costs of most businesses tend to keep up with inflation over time and so do their earnings. This protects them, over the long run, from the ravages of inflation. Stocks may not do well when inflation increases, but they do very well when inflation levels off or decreases. In the long run, they protect shareholders from inflation better than bonds.

Is unexpected inflation likely? Perhaps not in the short term, but over the next 3 to 5 years, I believe high inflation is very likely, and perhaps more than the 3% or 6% I referred to above.

Stocks aren't riskless, but neither are bonds. Stocks face more risk from default, but less risk from inflation. When government spending is expanding like never before and the Federal Reserve is printing money at a rapid pace, it's a good time to consider inflation protection and the fact that stocks may turn out to be less risky than bonds over the long run.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

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