How Bonds Can Bite

In 2009, investors poured a whopping $400 billion into bond funds, seeking refuge from the worst stock-market implosion in decades. That's understandable, given that bonds—essentially IOUs that promise fixed annual interest payments—are generally steadier, more predictable investments than stocks. But the flight to safety in a shaky economy has, ironically, made bonds riskier. Huge demand has driven up prices, and when bond prices rise, bond yields slip—and investors start taking more chances.

The Next Bubble

Here's the situation: Imagine a $1,000 bond that pays 4 percent interest, meaning its annual payment is fixed at $40. If the price doubles to $2,000, that $40 becomes a 2 percent yield—and who would be satisfied with that? Rising prices prompt investors to hunt for bigger game—riskier bonds and bond funds—to maintain their income. And like homebuyers who got in at real estate's peak, bond investors who pay the highest prices will suffer most when the bond bubble bursts.

Bonds were still a great buy a year ago as strapped corporations, states, counties, and cities vied to raise cash. In December 2008, for example, high-quality corporate bonds paying 7 to 10 percent a year could be had for 80 cents on the dollar. Thanks to such bargains, bond returns—their yield, plus or minus any change in market price—soared. In 2009 corporate bonds overall returned 17.1 percent, while junk bonds (issued by companies with lower credit ratings) delivered an astounding 58.2 per­cent return, the highest in 25 years.

Today bonds are much more expensive, yields are much lower (between 2 and 4 percent for the safest corporate bonds), and risk is much higher—yet demand keeps inflating the bubble.

"The biggest mistake bond investors are making," says Eleanor Blayney, consumer advocate for the Certified Financial Planner Board of Standards, "is to ask only what they can earn, not how much risk they're taking."

The Interest-Rate Threat

Bonds always carry three kinds of risk: default risk, inflation risk, and interest-rate risk.

Default risk is easy to understand. As a bond investor, you're a lender. If the company that issued your bond gets into financial trouble, you may not get your money back. (Enron and Lehman Brothers bondholders learned this the hard way.) Even a municipal bond issuer can default—as California's Orange County did in 1994. Inflation risk is the general danger that your return may lag behind inflation. But a pervasive, less obvious threat to all bonds is rising interest rates.

This basic truth sometimes confounds investors, who may assume that because bonds bear interest, rising rates are good. Not so! Interest rates and bond prices are like the two ends of a seesaw: as rates rise, bond values drop. Take that $1,000 bond paying 4 percent, or $40 a year. If rates climb to 5 percent, the bond can't be sold at full price anymore, because new $1,000 bonds pay $50 a year. Suddenly that old bond is worth only $800.

Bond funds have the same risks. If your fund's yield is 12 percent but its share price declines 15 percent, your real return is a 3 percent loss. That's how "safe" bond investments turn into money losers. Even U.S.-government bonds carry interest-rate risk.

Nowadays rates are so low—a key federal lending rate is near zero—that they can only go up. Indeed, the Federal Reserve may opt for steep rate increases to stave off inflation as the economy recovers. If interest rates soar in the next few years, even Treasuries and municipal bonds, generally the safest choices, could lose 30 percent of their value. Some corporate bonds could lose even more.