Attention Bond Investors: Danger May Lie Ahead

By Markets Fool.com

Bonds have enjoyed an epic run over the past three decades. Investors have enjoyed strong returns as interest rates have fallen, inflation has remained in check, and governments have implemented measures to further drag down rates. The good times for bond investors, however, may be coming to an end.

Continue Reading Below

It's true that market prognosticators have been clamoring for the end of the bond bull market for quite some time, and many who have bet that interest rates would rise have lost a fortune. So I understand if your first reaction is to disregard what I'm about to say. But please understand -- I'm not trying to call a bottom in interest rates. So many factors go into determining rates that to do so would reek of arrogance.

Instead, I'm simply trying to send a warning to bond investors, and particularly long-dated bond ETF investors, that what they (you?) might believe to be a safe investment could actually be fraught with risk. That's due to the relationship bond prices have with interest rates: As rates rise, bond prices fall. And the prices of longer maturity bonds, as represented by the iShares 20+ Year Treasury Bond ETF, can fall dramatically when rates increase:

Source: YCharts.

You may be asking yourself, "What if I just hold my bonds to maturity?" Here's what respected investment firm Charles Schwab has to say on the subject:

Continue Reading Below

For individual bonds, this price volatility may not be much of an issue if you hold your bonds to maturity. Barring default, you'll receive a known principal amount back at maturity.

Bond funds, on the other hand, don't have a set maturity date. You may find that when you need to get your money back, you have to sell shares -- and these shares may fetch a lower price than when you initially bought them in a rising-rate environment.

And considering that many investors typically increase their allocation to bonds near or during retirement -- a period when they're likely selling a portion of their assets to fund their retirement -- they may not be able to hold their bond fund or ETF investments long enough for the coupon payments to offset the negative bond price returns.

Before I go on, I want to be clear that further upside for bonds can still lie ahead, especially in the short term. The global economy is being affected by slowing growth in China, political turmoil in Europe, and plunging oil prices that some believe portend even more trouble ahead. If we enter a deflationary environment, then bonds can be exactly what you do want to own, as their prices would likely rise as investors fled to "safe-haven" investments. And few investments are considered safer than U.S. government Treasury securities.

But looking further ahead, I find it unlikely that rates here in the U.S. will remain at such low levels. The Federal Reserve has already ended its massive quantitative easing program, and it has hinted at rate increases in the near future.

In addition, a resolution in Greece that mitigates losses to its debt holders could help to reduce fears of a worsening economic situation in Europe. And the Chinese government would likely step in with new stimulus measures to reignite its economy should growth slow much more.

In combination, these factors could lead to a larger (and sooner) than expected increase in U.S. interest rates. But don't just take my word for it. Bond titan Bill Gross recently warned investors to "be careful when you're making a longer term commitment and interest rates are so low." Gross went on to state that bond investors should "be very cautious" if quantitative easing results in renewed growth in Europe while the U.S. economy remains on solid ground, since that could lead to a sharp increase in interest rates.

Most of all, I agree with Gross' belief that, "In the short term, bond investors are safe for six to 12 months, but not for ten to thirty years." As a long-term investor, I'm willing to incur short-term losses in the pursuit of much larger and, in my opinion, much more likely long-term gains.

The strategy I will be using to profit from this situation is to sell short the iShares 20+ Year Treasury Bond ETF. I expect the price of this ETF to fall over time along with bond prices as U.S. interest rates once again begin their ascent. And so, at least 24 hours after this article is published -- standard operating procedure for The Motley Fool's Real-Money Stock Picks program, which is designed to give Fools the opportunity to buy ahead of us should they so choose -- I will be shorting the iShares 20+ Year Treasury Bond ETF in my real-money portfolio.

The article Attention Bond Investors: Danger May Lie Ahead originally appeared on Fool.com.

Joe Tenebruso isportfolio manager ofTier 1 Investments, a Motley FoolReal-Money Portfolio.You can connect with him on Twitter@Tier1Investor. Joehas no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.