The Dangers Lurking in Bonds

Bonds have been on a tear for 30 years. From the start of 1982 through May of this year, Treasury notes with maturities of about five years returned an annualized 8.4%. Riskier 20-year Treasury bonds did even better, returning an annualized 11.1%, according to Morningstar.

The latter figure is higher than the U.S. stock market’s long-term return. Since 1926, large-company stocks have gained 9.8% annualized. And the stock market’s returns have come with a tremendous amount of volatility. Bonds are much less volatile.

But expecting bonds to perform as well in the future as they have over the past 30 years is silly and dangerous. Much of the gains over that period came from bond values rising as bond yields fell. But with Treasury yields at near-record lows (the yield is currently 1.5% for ten-year bonds), it’s as far-fetched to expect bonds to keep sizzling as it was to expect tech stocks to keep rising at the end of the 1990s. It’s time to tread very carefully in the bond market.

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At first blush, Treasuries look pretty appealing. The period from 1941 through 1981 was one of generally rising interest rates. Rising rates are bad for fixed-income investors because bond prices move inversely with rates. Yet the five-year Treasury still managed to return an annualized 3.4% over the period. Even the 20-year Treasury returned an annualized 2.2% (the longer a bond’s maturity, the greater its price swings in response to changes in rates). With the principal guaranteed by the federal government, the results don’t look so bad for the “safe” part of your investments.

But factor in inflation and you begin to see how costly bonds can be. On an inflation-adjusted basis, the five-year bond lost a cumulative 37.9%, or 1.2% annualized, over that 40-year stretch. Twenty-year bonds lost a cumulative 60.9%, or 2.3% annualized. By the 1970s, frustrated investors had begun to label government bonds “certificates of confiscation.”

Owning bonds during a period of rising interest rates isn’t like watching your house burn down. It’s more like having your house slowly devoured by termites.

After all, five-year government bonds have never lost more than 5.2% (on a total-return basis) in any single calendar year (that loss occurred in 1972). But counting inflation, five-year Treasuries lost 15.5% in 1946, the year after World War II ended.

What’s more, numerous economists and strategists say the Federal Reserve’s policies will result in years of negative after-inflation bond yields -- a phenomenon known as “financial repression.” Financial repression, in effect, takes money from holders of government bonds and transfers it to Uncle Sam.

Financial repression is a tool the Fed can use to bring down the national debt. With annual inflation at about 2% and the ten-year Treasury yielding 1.5%, financial repression is already under way.

Over the long term, government bonds have rarely been a way to make much money. Since 1926, five-year Treasuries have returned an annualized 5.4%, and 20-year Treasuries have returned 5.8% a year. But inflation over that period has averaged 3.0% a year.

Where to Invest Now

What’s an investor to do? To start with, never invest just for yield. Instead, hunt for total return. One good place to look: high-quality stocks, which can be found in funds such as Vanguard Dividend Growth (symbol VDIGX) and Yacktman Fund (YACKX). The funds yield 2.1% and 1.6%, respectively, but you stand to gain when the stocks they own appreciate.

Those of us who lived through the 1970s recall all too well that high interest rates can be devastating for stocks. But the Leuthold Group, a Minneapolis-based investment research firm, found that rates don’t get to be a problem until the ten-year Treasury rises above 5% or so. “Rising rates below that will be evidence that the U.S. economy is growing,” says Doug Ramsey, chief investment officer with Leuthold. “That’ll be good news for stocks.”

With your bond money, this is a time to be creative -- but not too fancy. That’s a tricky balancing act. “Be in segments of the market that aren’t correlated with interest rates: high yield, convertible securities and stocks,” says Kathleen Gaffney, co-manager of Loomis Sayles Bond (LSBDX), which invests in all of those securities -- and more. By the standards of bond funds, the Loomis Sayles fund is fairly risky. If the economy weakens, the fund will probably get clocked. In 2008, for example, it plunged 21.8%. Even so, it has returned an annualized 7.0% over the past five years through July 16.

Pimco Diversified Income D (PDVDX) is somewhat less risky. It invests in high-yield bonds, investment-grade corporate debt and foreign bonds, with a big stake in emerging-markets bonds in particular. It lost only 13.7% in 2008 and has returned an annualized 8.5% over the past five years.

Whatever you do, stay away from long-term bonds of all kinds, and don’t be tempted by overly generous yields -- they may indicate extremely low quality. I’d avoid Treasuries. Their yields are almost always lower than those of other bonds. (See Treasury Bonds: A Lousy Deal.)

Municipal bonds tend to offer a gentler ride than Treasuries. But keep your maturities relatively short. Vanguard Intermediate-Term Tax Exempt (VWITX) is my favorite. You can expect its share price to drop about 5% if rates rise by one percentage point. But you’ll still get the tax-free yield, currently 1.8%. That’s equivalent to a taxable yield of 2.8% for an investor in the 35% federal income-tax bracket.

A final note: Stick to funds. Individual bonds save you a bit on annual expenses, but they’re extremely costly for individual investors to sell. When rates start to rise, you can sell a bond fund in a day at net asset value. Not so with individual bonds. It will likely cost you 3% or more of a bond’s value to sell it before maturity.

Steven T. Goldberg is an investment adviser in the Washington, D.C. area.

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