What's the primary reason investors buy bonds? Safety. Those already in retirement buy them for the reliable, steady income they generate. Those looking forward to retirement buy them for stability, a counter-balance to the volatility that owning stocks brings to their portfolio.

But what if the safety bond investors think they are getting is a mirage? It's important to understand that while bonds protect investors against some risks — specifically volatility — they don't protect against all risks. In fact, bonds are particularly vulnerable to a specific risk SMI has been discussing quite a bit in recent months: Inflation.

A quick review of how bonds work will help illustrate why they are so vulnerable to rising inflation. A bond is simply an IOU — a promise to pay a certain amount of interest for a certain length of time. These IOUs are issued by government entities (federal, state, local) and corporations (such as IBM).

As an example, let's consider a hypothetical IBM bond with a face value of $1,000, a maturity date that's 20 years in the future, and an interest rate of 5%. In this situation, an investor would pay IBM $1,000, receive $50 per year in interest for the next 20 years, and then get his or her $1,000 back from IBM when the bond reaches its maturity date.

Now imagine inflation picks up and prices start to rise. Faced with rising prices on the goods and services they buy, savers and investors will no longer be satisfied with getting only 5% interest in return for locking their money up for long periods of time. They will demand more interest in exchange for lending their money, so they can continue to buy the same goods as before with their interest payments. Thus, bonds being issued in this new environment will be forced to pay a higher rate of interest — say 7% ($70 a year) — to attract investors. This is why interest rates tend to rise when inflation — or even the threat of future inflation — takes hold.  

The nature of interest-rate risk

But what happens to our original IBM bond when interest rates rise? Remember, the interest rate is fixed, so the $50 its owner receives stays the same. Unfortunately, due to the inflation, that $50 no longer buys as many goods as before and therefore the value of the bond is diminished. If its owner wishes to sell it, he or she will have to set an asking price lower than those of the new bonds paying $70 a year.

In other words, nobody wants to pay $1,000 for a bond paying 5% interest when there are new $1,000 bonds available paying 7% interest. It's inescapable: as interest rates rise, bond values fall.

While this dynamic, called "interest- rate risk," is always present with bonds, a combination of short-term and long-term trends makes this a particularly relevant topic right now.

Looking at the long-term trend, interest rates have been in decline for most of the past 27 years. As rates have declined, we've witnessed the opposite effect of our example — falling interest rates have propelled bond values higher. It's been a great time to be a bond investor. But with rates so low currently, it's difficult to see how they could possibly go much lower, and easy to see how and why they could trend higher.

We've spent a great deal of time in recent months detailing the national spending/borrowing trends and their impact on the U.S. dollar, so we won't revisit that territory. But suffice it to say, there is no shortage of potential catalysts for higher interest rates. They include, to name a few, the Fed ending it's "monetizing the debt" program which has been artificially suppressing interest rates, the Chinese becoming more outspoken about their unease with current U.S. fiscal policy, and the world's monetary community openly talking about finding alternatives to the dollar as an international reserve currency.

Determining the exact timing as to when these trend shifts will occur or impact the markets is notoriously difficult. But it seems inevitable the pendulum will swing back in the direction of higher interest rates.

Quantifying the risk                                                                              

The key question, then, is how much do bonds stand to lose if interest rates do start moving higher? This is a somewhat imprecise exercise because we don't know how fast and how far interest rates will rise, or when that move might start in earnest. So while we can illustrate the principle, we're largely left guessing at the specifics.

Here's a start though. From 1926 through the present, the median inflation rate has been just a bit under 3.0%. That's important to know, because over the past 50 years or so, the 10-year Treasury has averaged a "real" interest rate (the rate after inflation) of roughly 2.5%. When you put those two facts together, you get a "normal" rate expectation for the 10-year Treasury of about 5.5%. (To be more precise, the actual median yield over the past 50 years for the 10-year Treasury has been 6.21%; this number is a bit higher than the 5.5% mentioned, due to mixing two slightly different time periods, as well as the differences between "averages" and "medians.") So it's not at all aggressive to expect the 10-year Treasury to climb back towards the 5.5% level, as that would simply represent a return to normal conditions.

The current yield of the 10-year Treasury bond is 3.50%. And what will happen when interest rates rise toward 5.5%? Uh oh.

In early 2003, SMI published an excerpt from a Vanguard educational booklet explaining the impact of rising interest rates on various types of bonds. That booklet suggested that a 2% increase in interest rates would cause short-term bonds to decline in value by 5%, intermediate-term bonds to lose 10%, and long-term bonds to fall 20%. (Remember, a 2% increase in rates is what would be required simply to move from the current 10-year Treasury rate back to "normal.")

The rapidity of the rise in rates is a key factor

That information from Vanguard is helpful in illustrating the impact of rising rates on bonds of varying maturities, but it leaves out an important variable — specifically, how long it takes for interest rates to rise that much. After all, interest rates don't tend to jump like that overnight.

Thomas Atteberry, co-manager of the FPA New Income bond fund, has run the numbers on a similar projected increase in interest rates using different time frames (as reported in the Aug. 31, 2009 Wall Street Journal). His analysis indicates that if interest rates were to return to their historical norms and that rate move was to occur over the next five years, bond investors would still be in positive territory: Treasury investors would earn 1.1% per year, while investment-grade corporate bond owners would make about 3.3% per year.

However, if rates reverted to those norms more rapidly, say over the next year, Treasury investors would lose almost 16%, while corporate bond investors would lose roughly 9%. Even worse, all of those numbers are before factoring in the impact of inflation on returns.

All of which is to say that while bonds continue to help shield investors from volatility risk, they aren't likely to help much if inflation picks up in a significant way, as we're concerned it will eventually. Government bonds lost an average of 3.4% per year between 1973-1981 after inflation was factored in.

Conclusion

While our recent gold coverage has been more intense than most topics, it's because we view the inflation threat as being significant and one that many investors (especially those with bond-heavy asset allocations) aren't well prepared for. That's particularly true given that the impact of higher inflation would likely hit investors in the part of their portfolio where many would least expect it: their supposedly "safe" bond holdings.

This is also why we've discussed carving any gold holdings out of your portfolio's bond allocation rather than your stock allocation. We hope that by looking at this in more detail, we've better explained why we are suggesting that particular course of action.

As always, it's good to remember we're dealing with investment probabilities here, not certainties. As such, and because the timing of this trend change isn't necessarily predictable even if the actual prediction turns out to be accurate, we still recommend you make measured, as opposed to dramatic, changes to your portfolio.

Adding defensive investments such as gold to protect against the specific threat of inflation is one possible step. Replacing some traditional bond holdings with TIPS (inflation-protected government bonds) is another. And keeping your bond maturities short also seems to make sense in light of the pending inflationary threat. (Interest-rate risk is less pronounced with shorter-term bonds than with longer-term ones. If our hypothetical IBM bond matured in three years rather than 20, the owner would have had to endure the lower $50/year returns for only a brief time. The bond's value would diminish relatively little.)

October 28, 2009

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