Beware of Bonds!

10/24/2017 12:55 pm ET

If you’re worried about protecting your stock market profits, where can you hide? That’s the dilemma facing many investors who want less exposure to the stock market at this stage of their life, especially considering the incredible gains of the past ten years.

Unfortunately, too many people have told me they are “hiding” from the stock market by buying bonds. So let me make one point very clear: You can lose as much money in bonds as you can in stocks.

This is not an issue of bond defaults — the failure of companies or governments to make the promised interest payments. That problem can be avoided by sticking to highly rated bonds or to bond funds that buy only top-rated debt.

The greatest risk of bonds — and the least understood — is “market price risk.” It’s the risk of bond price declines when interest rates are rising. We have been a falling rate environment for the past two decades. What happens when rates move higher, either because the Fed acts or because a sudden fear of inflation makes today’s low-yielding bonds less attractive?

In an inflationary environment, new debt will be sold carrying much higher interest rates to attract buyers. Even the U.S. government and triple-A rated companies will be forced to pay higher rates when they borrow, since buyers will want to be compensated for the fear that the dollars they get back when the bond matures will be worth less as a result of inflation.

If that situation happens, no one will want to pay the full “face value” (typically $1,000) for your old 10-year Treasury bond that carries in interest rate promise of “only” 2.3 percent. If you need to sell to take a mandated distribution, you will get far less than face value. You’ll sell at a loss. And the longer the maturity of the bond, the larger the price decline.

That’s the real danger in bonds: When interest rates rise, bond prices fall.

Of course, if you hold the bonds, you know you’ll get your $1,000 back when the bond matures. But in the meantime, you’ll be stuck with a low yield that may not compensate for annual inflation. And what will that $1,000 be worth in spending power 10 years from now?

Where to hide?

That leaves people in a dilemma. Stocks could go higher, and likely will if there’s a tax package. But stocks could also fall sharply from these levels. Prudence dictates diversification. But the most “obvious” diversification — bonds — carries its own risk of lower prices.

The other alternative is very short-term safe investments like money in the bank or money market mutual funds. But as everyone knows, those “chicken money” choices don’t pay very much interest.

Actually, short term interest rates have been creeping higher. A year ago, a six-month Treasury bill paid less than one quarter of one percent. Today it yields 1.26 percent. That’s not a lot – but it seems the market is anticipating the Fed’s next move or inflation on the horizon.

Hiding out in money market funds is certainly not a long-term investment strategy (although I always recommend having a “chicken money” reserve in every stage of your life). But at this point, it might be a safer alternative for those in or nearing retirement than having all of your money in stocks or bonds.

If your assets are held mostly inside a 401(k) or 403(b) plan, most offer a safe haven of a “stable value fund” designed to pay a low rate of interest and safeguard principal. And you can move some of your IRA into a money market mutual fund.

Know your exposure

This advice is a reminder to those whose life plans and retirement schedule would be dramatically changed by a big decline in the stock market. Younger people can ride out any huge market declines. In fact, for them a drop in the market is an opportunity. That monthly contribution will buy more shares at lower prices, giving a bigger bank for their buck when the market eventually rises.

But if retirement looms, think about finding a safe haven — at least for the portion of your money you’ll need in retirement. You don’t want to learn about bond price risk when it’s too late. And that’s The Savage Truth.

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