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Bonds too risky to qualify as a safe investment

Tuesday, June 23rd, 2015

Bond investors have gotten a scare for the past couple of weeks as they have seen interest rates spike more than usual.

Many bond investors continue to sit tight and hope things will be OK. Unfortunately, they don't understand the sensitivity to the correlation of rising interest rates versus bond prices.

For example, investors who hold a 20-year bond would experience a 13 percent decline in the value of their bond if interest rates were to increase just 1 percent.

Just imagine if, over two years, interest rates went up 2 percent, which would put the 10-year treasury at about 4½ percent — nothing unusual or high. But in a two-year timeframe, that bond investor would experience a roughly 26 percent decline in the principal on a 20-year bond.

Using the interest rate you are receiving on a bond, you can figure out how long it would take to get back to breaking even.

Yes, the number is shocking. For instance, if that 20-year bond were paying a 5 percent interest rate — which is actually high for today's market — it would take more than five years just to break even. And that doesn't include what happens if interest rates were to climb higher.

I experienced this pain back in the spring of 1987 as a young man rather new to investment world. I had the misunderstanding that bonds were safe, as I was told by people I thought were smart individuals.

As it turned out, those smart individuals were more concerned with selling bonds to generate a commission off investors than they were with understanding that maybe this was not a good time to be investing in bonds.

As a side note, that was one of the reasons I became a money manager who charges a fee as opposed a commission. If the best thing to do is keep some of the funds in the money market to protect the principal, then that is what I do, but I'm not making a commission.

Fast forward to 2015. I now have accumulated years of knowledge that tells me this is not a time for bonds. I have a very long memory of the pain I saw investors suffer, especially because they thought bonds were safe.

The rules are still the same but the difference is now I understand what is known as the Macaulay Duration, which is a formula to figure risk on bonds.

Some people ask where else they should invest their money and I explain that there are still some good buys in the stock market, where an investor buys a small piece of a large company.

This requires a lot of research, but I don't understand why some people are so afraid of stocks, which, although they fluctuate and could go down 10 or 15 percent, would not be as much as a 26 percent decline in long-term bonds. And keep in mind it is possible for interest rates to go much higher than just a 2 percent decline.

I will also issue another warning to investors in utility companies who are finding all kinds of reasons why their utilities are different this time and will not be affected by rising interest rates.

There are two risks with utilities. First is the interest rate risk and second is the valuation risk. And once again, investors think the stock market is expensive, which in reality it is not. Besides that point, utilities are trading higher than the stock market, with higher valuations as the measurement.

Investors have lost more money by putting their heads in the sand and hoping for a different result. No one knows exactly when interest rates will go up. But when they do, many investors will be shocked at the loss of their principal.

Do you have a question or a company you'd like me to take a look at? Email me at Brent@WilseyAssetManagement.com!


Wilsey is president of Wilsey Asset Management and can be heard at 8 a.m. every Saturday on KFMB AM760. Information is provided by Reuters.

 

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