Thought Bonds Were Safe? Think Again
Investors have spent the past year or so relearning an important lesson: stocks are risky. From May of last year to March of this one, stocks in the U.S., as measured by the S&P 500 index, lost more than half their value. Many overseas stock markets did even worse.
After being burned, we humans tend to avoid what singed us and seek something soothing. High-quality bonds — in particular, the "risk free" ones issued by the U.S. government — were the most soothing investments of all during the financial crisis. While stocks were losing more than half their value, 10-year Treasuries returned more than 10% during that May-to-March period. And so — big surprise — investors have poured $240 billion into bond mutual funds so far this year, according to the Investment Company Institute. Stock funds — despite a big rebound in stock prices since March — have taken in less than $15 billion. (See 10 things to buy during the recession.)
Makes sense, right? Stocks, risky. Bonds, safe. Or at least safer. But risk in financial markets has an irritating habit of following investors around. The big rush into bonds — especially high-quality, low-risk bonds such as Treasuries and government-guaranteed mortgage securities — may have created a situation in which most of today's bond investors are bound to lose money. Not 50% losses, as in the stock market, but losses nonetheless. Which for many newcomers to bonds will be a big shock.
"They lost money on their house, they lost money on stocks," says Tom Atteberry, co-manager of the FPA New Income mutual fund. "They put money in bonds because they think it's safe. Then interest rates are going to rise on them, and they're going to lose money on bonds too."
The first time I heard Atteberry say this, I thought my ears needed cleaning. You see, FPA New Income is a bond fund — a very successful one. The mutual-fund raters at Morningstar named Atteberry and his co-manager and boss, Robert Rodriguez, 2008's fixed-income managers of the year. Yet Atteberry sees only trouble ahead. "I've got a bull market in bonds that's unsustainable," he contends. "It might last another six months. It might last another year. Is it going to last another three to five years? I don't think so."
Before we get into the details, it's worth going over the difference between stocks and bonds. When you buy stock, you get part ownership of a company. If it does well, you share in the gains. If it flounders, you lose money. Bonds, on the other hand, represent a promise from a company or government or other borrower to pay you back, with interest. When you buy a bond, you're making a loan. Sometimes bond issuers (a.k.a. borrowers) renege on their promises. The financial crisis originated with a rash of defaults on subprime mortgages that had been packaged into bonds. But the bond risks that vex Atteberry have little to do with that default risk — Uncle Sam will make the payments. The worry is over rising interest rates. (See pictures of retailers which have gone out of business.)
Right now the interest rate on a 10-year Treasury bond is about 3.5%. That could go lower — in fact, it did go lower at the height of the panic last fall, to just above 2%. But the likeliest future path for Treasury yields, Atteberry figures — on the basis of history and the fact that rates have been kept low this year by Federal Reserve purchases, investor demand and other factors — is up. If you own a 10-year Treasury bond yielding 3.5%, interest rates rising to 4% or 5% or higher mean your bond (with its rate stuck at 3.5%) falls in value. That's the logic of bonds: when interest rates rise, bond prices fall. Since 1981, when the 10-year Treasury rate topped 15% amid fears of runaway inflation, the interest-rate trend has been downward, bringing on a long bull market in bonds. One of these days, the trend will shift.
Atteberry is hoping to navigate the minefield ahead by holding only bonds that come due soon, which are less sensitive to changes in interest rates (but also have a lower yield than longer-dated bonds). He may ask FPA New Income's board for permission to increase the fund's limit on foreign bond holdings from its current 10%. And he has positive things to say about the inflation-indexed bonds that Treasury has issued since 1997, although he doesn't think they're a particularly good deal now.
Most bondholders, though, will find it hard to avoid losses. And what will retail investors do once bonds have burned them too? Atteberry thinks many will just put their money in the bank. The trade-off there is a measly return: the highest savings-account rate in the land is currently just 1.83%, according to Bankrate.com and most banks pay far less. Less than inflation. But hey, at least the money's safe.
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