What’s So Scary About Long-Term Bonds?

long-term-bondsThe way long-term bonds are frequently discussed by the media, some investors might think they are a type of financial-markets disease, to be avoided at all costs. I’ve never quite understood this. While I don’t think a 100% allocation to long-term bonds is prudent, neither do I think a 0% allocation is a good idea. In this article, I would like to address four reasons for avoiding long-term bonds that you may have come across at one time or another.

1. In a nutshell, when people refer to interest-rate risk in a discussion about bonds, they are referring to the risk of bond prices falling as interest rates rise. I am of the opinion that long-term-focused individual bond investors should purchase bonds with the intention of holding those bonds to maturity. If investors do this and also manage their liquidity appropriately (this includes laddering a bond allocation), then interest-rate risk should be of little concern. On the other hand, investors who purchase non-defined-maturity bond funds should care much more about interest-rate risk, as the value of their principal could decline and never return to their cost bases. It is for this reason that I heavily favor individual bonds within my portfolio’s fixed income allocation.

That’s not to say that I think bond funds are never worth considering. As I mentioned in The Insider’s Guide to Income Investing, there are two reasons why I might purchase a bond fund: “First, if I want exposure to a particular part of the bond market but am uncomfortable buying individual bonds in or unable to adequately diversify in that part of the market. Second, if I can purchase a fund with a low/short duration at an attractive price (enough to provide what I consider a margin of safety).”

2. In contrast to interest-rate risk, as an individual bond investor, I care much more about credit risk. I have been fortunate to never have a bond I own go into default. But because that is a risk, I am careful to diversify my portfolio in a way that it can handle defaults without causing me any undue hardship.

3. Inflation should be a concern of every long-term bond investor. I think it is impossible to predict with any accuracy how inflation will behave year-in and year-out over the course of a few decades. But longer-term bonds purchased at yields that historically would have provided inflation-adjusted returns over a long period of time help to mitigate this risk. Of course, the past is not a predictor of the future, and each of us will have to judge which historical experiences we want to assign more weight to when investing.

4. It seems like there is a never-ending chorus of financial voices ready to tell you that buying bonds today is not a good idea because if you wait, you’ll be able to lock in higher interest rates in the near future. At any particular moment in time, this may or may not be true. For investors willing to try to time the market, perhaps this is good advice. But for those who recognize the opportunity cost of trying to time the market and being wrong, it might not make sense to forgo purchasing a bond at a price you find acceptable given the level of credit risk simply because it might trade at a lower price in the future.

To review, four things that make investing in long-term bonds a scary proposition for many investors include interest-rate risk, credit risk, inflation, and not wanting to lock in lower rates because of the belief that rates will soon head higher. But if you hold your bonds to maturity, ladder your allocation, diversify, purchase at yields that have historically provided “real” rates of return, and recognize the opportunity cost of trying to time the market, you might discover that long-term bonds aren’t so scary after all.

More from The Financial Lexicon:
Income Investing Insider Newsletter
The 5 Fundamentals of Building a Retirement Portfolio
Options Strategies Every Investor Should Know

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