Published March 20, 2013
Allow me a brief moment to comment on the “Great Bond Myth.” We all have been taught bonds are safe. They can be, but there is a good chance they are not all you think they are.
There are three different risks in a bond. First is interest rate risk. A bond’s price is sensitive to interest rate movements -- as interest rates climb from historic low levels, the principal value will decline. The second is credit and default risk. There can be many economic events that may hinder a corporation from repaying this debt to you, such as the collapse of Enron or Lehman Brothers or a company downgrade. The company’s poor earnings prospects may cause a downgrade in the bond’s rating from A rating to B, and this will cause the principal value of the bond to drop. Interest-rate risk and credit risk may not be a problem if you hold the bond to maturity and the corporation or issuer of the bond still has the ability to pay back the money you loaned when the bond matures.
The third inherent risk to bond owners is Longevity Risk. Short-term coupon bonds are gone forever. Today most bonds’ maturity is longer than 20 years, and some even 30 years. Realistically, will you ever hold a 20- or 30-year bond to maturity? If you don’t, you have much of the same open market risk as stocks and you have to accept the going market price on the day you sell them. Bonds now have market risk without any real upside growth potential for taking the risk.
More important to note is most people own their bonds in a bond mutual fund, eliminating all of the safety. If you do not own the individual bond, you can not hold it to maturity. You own stock in a bond mutual fund. Why do most people own bond mutual funds? It is because their broker is paid a 4% commission on bond mutual funds, verses a tiny commission on real bonds.
The “Great Bond Myth” says bonds bring little safety to an investment portfolio, so why bother with today’s low yields? With that being said, people do not know, or have ignored, the risks in their bonds. Simply, they have not been advised about this problem or have not heard of a better idea.
Investors should learn about available fixed income alternatives; many have higher yield potential. There are alternatives that will shorten maturity to 10 years or less, some which eliminate credit risk and interest rate risk, preventing annual decline of principal when rates go up. Most important, though, is compounding interest every year with safety; this is what your bonds were supposed to do.