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Last 2 months prove you can lose money in bonds

Updated: May 3, 2013 12:14PM

Originally published: August 7, 2003

We’ve had an astounding bear market in the last eight weeks. Not in stocks. In bonds. And if you haven’t opened your mutual fund statements recently, or checked the current market value of bonds you own, you might have missed it.

A reader asked why he was losing money in his bond fund, even as “Mr. Greenspan has been cutting interest rates.” But while Fed Chairman Alan Greenspan can control overnight interest rates--the fed funds rate--he can’t control what happens to interest rates in the huge global market for Treasury debt.

And in that free market, interest rates have soared dramatically. On June 13, the 10-year Treasury note had a yield of only 3.11 percent, a 45-year low. Since then, rates on the 10-year note have soared to around 4.5 percent. That translates into a loss of $110 per $1,000 bond--an 11 percent loss of principal in just two months! That’s equivalent to three years’ worth of interest, notes Jim Bianco of Arbor Research.

You can’t say you weren’t warned. On April 3, this column sent a message to “chicken money” investors:

“Those low yields tempt savers to stretch for income by purchasing longer-term notes and bonds. But even the highest-rated securities from the U.S. government will lose principal value when interest rates start to rise again someday. Then if you have to sell before maturity, you could take a loss. Or be stuck earning lower than market rates.”

What caused the bond bear?

Two months ago, the markets were worried about deflation, a slowing economy, falling prices and excess capacity in factories around the world. So to stimulate growth, the Fed cut the fed funds rate to historic lows.

But now, longer term rates are rising in the freely traded bond market. Has the economic outlook changed that much in two months? Not really, although some economic reports do show signs of improvement.

It’s more likely that the bond market is reacting to the Fed’s promise to do everything possible to fight deflation, including creating new money. That would be inflationary--an alternative the Fed seems to prefer.

Again there were warning signs, noted here on June 19:

“You can cast doubt upon the future value of your currency by signaling that you’re willing to print a flood of new money to spur your own domestic economy. Who would want to hang on to money that is losing value every day? And that’s exactly what the United States is on the road to doing.

“Last November, Fed Governor Ben Bernanke promised in a speech that the Federal Reserve would do everything in its power to keep America from sliding into deflation. . . . In effect, the Fed governor was promising inflation--a signal that the gold market and the currency markets understood immediately.”

And how does the bond market react to fears of inflation? If you’re going to lend money in inflationary times, you definitely want to demand higher interest rates to compensate for the loss of purchasing power.

What’s next?

That’s the multi-trillion dollar question. It’s a question not only for individual investors, but for the global central banks that now hold billions of dollars worth of U.S. Treasury debt.

We sent all those dollars abroad to pay for imports. Now the Japanese central bank holds $429 billion of Treasuries, and China’s central bank holds $122 billion. They’re losing money on those investments as bond prices fall, but then they don’t have much choice since they’re stuck with so many dollars.

You probably don’t share that problem, too many dollars to invest. So you should make some smart choices. But that doesn’t make it easy.

If the Fed does promote inflation to get the economy going again, you’ll be happy sticking with short-term chicken money in bank certificates of deposit, money market funds and T-bills to capture the rising rates.

If prices continue to weaken

On the other hand, if there’s just too much global overcapacity and prices continue to fall (deflation), you’d be happy to lock in today’s higher rates for a few years at least.

Since no one knows the future direction of interest rates for sure, you’ll have to make that decision for yourself. But don’t delude yourself into believing that you can’t lose money in government bonds. It’s happening right now.

And that’s The Savage Truth.

Terry Savage is a registered investment adviser and is on the board of the Chicago Mercantile Exchange and McDonald’s Corp. She appears weekly on WMAQ-Channel 5’s 4:30 p.m. newscast.

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