It is a simple fact that bonds today, given the low interest rate environment, are being priced with historically low yields. Further, with the threat of a higher rate environment looming, investors are fearful that buying a bond today won’t be as lucrative as buying a bond a year from now. For these two reasons, many investors view bonds with much skepticism, as risky, or even as being in a “bubble.” I generally understand the skepticism – but bond risk can be mitigated by purchasing issues that minimize the potential forward pitfalls. And while I do concede that it’s possible that certain portions of the bond market (long duration issues) could viewed historically as being in a bubble, it is based on a lot of interest rate speculation.
To see a list of high yielding CDs go here.
As I mentioned in last week’s LearnBonds article, a robust stock market is probably also impacting the elevated negativity on bonds. A five year bull run I believe has emboldened some investors who may have forgotten just how scary a stock market sell off can be.
In any case, investors that are trying to risk manage a portfolio need to consider a variety of factors: some that are investor specific and some that are market specific. One must mesh personal risk tolerance, goals, and capital base alongside current market realities and forward perceptions to achieve a baseline on which to structure a portfolio.
In last week’s article I mentioned that some investors may have little or no need for bonds. A young investor with little monetary base, that needs to maximize capital growth should place little focus on bonds. Thus it would be risky for a working 30 year old with an average salary to be investing for their retirement in 2-5% yielding bonds, simply because bonds currently do not offer much growth potential – even if the bonds themselves don’t pose much capital risk.
By a similar token, it may not make much sense, and would be considered risky, for a 70-year old multi-millionaire retiree to have all their money in growth stocks. A more balanced portfolio, including a sizable allocation to bonds and less risky dividend equity would be more appropriate in that scenario.
Those that say that bonds are in a bubble are speculating that interest rates will rise a bundle over a very short time period. So if you invest in a 30-Year corporate bond with 6% coupon and duration of 14 years, on paper you will lose 14 percent of your capital each time interest rates rise by 100 basis points (1%). So roughly speaking, in the unlikely event that you buy that corporate bond and wake up tomorrow with the Fed announcing a 350 basis point increase in rates, you’ll be down 50% on your bond. If you had bought a 10 year, 4% corporate bond, you’d only lose about 30% of your investment, on paper.
But the chances of a 350 basis point move even over the course of several years may be unlikely given current macroeconomic realities, so my personal view is that bond bubble pundits are blowing a lot of hot air.
And even if you do get caught in a rate updraft, your 30 year bond pays you 6% a year, which will earn you 60% a decade and 180% over the life of your bond. An investment of $10,000 earns $6,000 over three years and $18,000 worth of interest over the life of the bond.
For those that say that stock returns always better bond returns over time, I hearken you back to the growth stock bubble that ensued around Y2K. If one was unlucky enough to invest a bundle in the S&P 500 Index (SPY) in early 2000, it took 13 years to see a capital return (see chart below). While I’m not necessarily predicting such a forward equity malaise, investors must keep expectations reasonable. Historical stock returns are not what we’ve seen over the past five years.
So is a bond riskier than a stock if it earns you 6% a year – even in a rising rate environment – for 13 years when the stock market does nothing? Something to consider as you contemplate the question of whether bonds are riskier than stocks.
About the author:
Adam Aloisi has over two decades of experience investing in equities, bonds, and real estate. He has worked as an analyst/journalist with SageOnline Inc., Multex.com, and Reuters and has been a contributor to SeekingAlpha for better than two years. He resides in Pennsylvania with his wife and two children. In his free time you may find him discussing politics, playing golf, browsing antique shops, or traveling.