Updated: May 3, 2013 12:14PM
Originally published: November 19, 2002
Looking for a safe place to store your money? Dismayed by CD rates in the 1 percent range? Understandable, but don’t rush into bonds seeking safety or higher yields. A bear market in bonds can be just as vicious as a stock market crash.
A record $28 billion flowed into bond mutual funds in July, followed by another $17 billion in August, according to the latest reports. It’s a good bet that most of those bond investors aren’t aware of the danger. They’re just looking at the higher interest rate on longer-term bonds, compared to CDs, and the guaranteed return of principal. But a lot can happen between now and then.
Why bonds are risky
There are two risks in owning bonds. One is quite obvious to most investors. It’s called credit risk. That’s the risk that the company will go bankrupt and won’t be able pay the interest or principal on the money it owes you. You can avoid credit risk by purchasing only the highest-rated bonds--or a mutual fund that buys only top-rated bonds.
Companies with shaky prospects may sell bonds to borrow money. But their bonds carry more risk, so the company is forced to pay a higher rate of interest. Those are called high-yield, or “junk,” bonds. The high yields may be extra tempting, but don’t forget about the extra risk.
There’s another, less obvious risk in buying bonds. It’s called market risk. It’s the risk that the $1,000 you spend to buy a bond--or the $10,000 you invested in the bond fund--will fall in value, much as stock prices have fallen in value. What makes bond prices decline? Rising interest rates.
The managers of those bond funds with all the cash inflows have had to put that money to work by investing in bonds at the lowest rates in nearly 40 years. But once you’ve locked up 5 percent or 6 percent on a corporate bond for 30 years, what happens if rates rise?
When interest rates rise, bond prices fall.
If the economy starts growing again, and interest rates rise next year, then new corporate borrowers will have to pay higher rates of interest. No investor will want to pay you $1,000 for your 5 percent bond, for example, if highly rated companies are paying 7 percent to sell new bonds. If you need to sell your bond, you’ll get only about $900, which has the effect of raising the yield to the new bondholder--even though the company is still doing well, and able to make all its interest payments.
A lot of people have been rushing to buy mutual funds that specialize in Ginnie Mae securities. Although government-guaranteed, they pay a slightly higher rate of interest than the safest Treasury securities, because Ginnie Maes are really packages of mortgages.
But here’s another risk in owning bonds--prepayment risk. It can take place in several ways. Ginnie Maes are a perfect example. Homeowners have been refinancing as rates drop. Their old mortgages get paid off, and they take out new ones. When the old mortgage is paid off, the cash is distributed back to the lender--which means owners of Ginnie Mae bonds or funds. Then the investors are stuck with cash that they now have to reinvest at lower yields.
If rates subsequently rise, people won’t refinance, so the prepayment problem will go away. But then investors will be stuck owning a package of low-yielding mortgages. That won’t be such a great investment if interest rates rise. Once again, if they try to sell, they’ll get less than the amount they initially invested.
Sometimes companies have the ability to prepay bonds if rates drop. After all, no company wants to keep paying out 8 percent or 9 percent to bondholders when interest rates are so low. That’s why it’s smarter to invest in a bond fund, where the fund manager does the homework to buy bonds that can’t be prepaid.
Getting outsmarted in bonds
The big question is when rates will rise again, as they surely will.
If you’re a borrower, you’re smart enough to lock in today’s low mortgage rate for 30 years because you know it’s a bargain. But if you have money to put to work, you become a lender--the other side of the market.
Don’t outsmart yourself in the search for higher yields by locking in bonds at today’s lowest rates in history. Chicken money belongs in short-term bank CDs, money market accounts, or Treasury bills. If you’re getting higher yields, there’s more risk involved. And that’s The Savage Truth.
Terry Savage is a registered investment adviser and is on the board of directors of McDonald’s Corp. and Pennzoil-Quaker State Co. Send questions via e-mail to firstname.lastname@example.org.