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How Bonds Can Bite

Bonds are safe, right? Not so fast. Prices are high—and so are the risks.


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.


Steps to Safety

1. Check default risk.

In a U.S.- government bond fund, you don't have to worry. For a corporate bond fund, review the prospectus. You want an "investment grade" fund, which means the fund buys bonds of companies with the highest credit ratings.

2. Find out interest-rate risk.
The key factor is your fund's "average duration," which you'll find in the prospectus. The longer a fund's duration, the more you'll lose when rates rise. A bond fund that has "long-term" in its name is usually much riskier than a "short-term" fund. But don't rely solely on the name.

To find out what a rate increase might cost you, multiply your fund's average duration by the hypothetical rate increase. Let's say your fund has a three-year average duration. If interest rates were to rise 2 percentage points, you could expect a 6 percent drop in market value. The same rate increase might erase 20 percent from a bond fund with a ten-year average duration.

3. Consider your timeline.
If you won't be tapping a short- or intermediate-term bond fund for at least ten years, you have less to fear from interest-rate risk. As rates rise, your reinvested dividends will buy new, higher-yielding bonds; over time, the income from these can offset the short-term drop in the fund's value.

4. Reallocate your money.
If your bond choices seem risky based on what you've learned, transfer your dollars to safer choices. Again, look at the fund's prospectus. Three good categories to consider:

A short-term bond fund
Opt for atop-quality fund that has an average duration of under three years and buys only government bonds or investment-grade corporate bonds. To maximize your return, pick a fund with very low expenses. A few examples: Vanguard Short-Term Bond Index Fund; T. Rowe Price Short-Term Bond Fund; JPMorgan Short Duration Bond Select; and USAA Short-Term Bond Fund. (Beware of "ultrashort" bond funds, which often boost yields by buying inherently riskier low-quality bonds. In 2008 ultrashort funds that held subprime-mortgage instruments had devastating losses.)

A ladder of CDs
Certificates of deposit are very low-risk bond investments. With a ladder, you divide your money equally between, say, five CDs of different maturities ranging from one to five years. You'll earn more than you would if you put all your money into a one-year CD. And every year a CD that's maturing will give you cash to reinvest as interest rates rise.

A stable-value fund
If you participate in an employer-sponsored retirement plan such as a 401(k), you may have this option. Stable-value funds invest in government bonds and high-quality corporate bonds, and they have insurance to protect your principal against interest-rate risk. Investors have rarely lost money in such funds, but be forewarned: their insurance generally doesn't cover losses caused by an employer action that prompts workers to cash out in droves, such as a mass layoff or a bankruptcy. When Chrysler was on the verge of bankruptcy in 2008, for example, so many employees cashed out of a stable-value fund set up for its white-collar workers that it had to be liquidated, paying only 89 cents on the dollar.

5. Don't panic.
It still makes sense to invest in bonds. You just need to remember that your primary goal as a bond investor should be safety, not a high return.

Contributing editor Lynn Brenner reported on new rules for Roth IRAs in the March–April issue.