Why bonds may not be safe

If you have been following financial news, you may realize what the most prominent story on bonds has been since the financial crisis of 2008: historically low interest long-term Treasury bond yields. You may also know that this was caused by investors unwilling to take risk with stock investments and feeling more comfortable putting their money in bonds, which are a lot safer. Common knowledge states that bonds are basically a guaranteed returns investment vehicle.

What is a bond? A bond is a certificate of debt that carries periodic interest payments and pays back the face value, or principal, at the end of a fixed period. In finance terms, the interest payments are called coupons, and the face value is called a par. The period between when the bond is issued and when it pays back the principal is called maturity. When you buy a bond, you are guaranteed coupon payments and the return of principal at maturity. For  example, if you buy a bond for $1,000 that pays $50 a year for 30 years, every year the bond pays you $50 like clockwork, and after 30 years it pays you back the original $1,000.

Bond = par + coupons

Maturity = time redeemed – time issued

As long as the bond issuer does not default or go bankrupt, you will receive these payments. Then even if the bond issuer goes bankrupt and liquidates their assets, they have to pay bond holders before share holders. Unlike bond investment, stock investment does not provide any guarantee on the returns: if the company’s financials go downhill, you can lose up to 100% the value of the stock you own. A share is basically a representative little piece of a company: its ups and downs are integral with the ups and downs of the issuing company. A bond, on the other hand, is a liability that does not fluctuate once issued.

So there is nothing to lose when you invest in bonds, except for the rare occasion where the issuer defaults and refuses to make coupon payments, right? Actually, even if the bond issuer is Scrooge McDuck who never encounter financial problems, investing in bonds can be a risky business.

In economics, there’s this thing called opportunity cost. If you have not taken an economics course, let me explain this concept through a simple example. Let’s say Andy pays $1,000 for a bond that pays $50 a year, which makes the coupon rate 5%. At the same time, Beth buys a bond of the same quality that pays coupons of 8%. Sure, Andy is still making money from his bond investment, but he’s also losing 3% per year compared to what he could have done: buying the bond that pays 8%!  But again, he is not losing any money. He only loses money when compared to Beth’s investment. The coupon rate on Beth’s bond represents Andy’s opportunity cost: the cost of foregoing his money to invest in the 5% bond.

When you make an investment, it’s very important to account for opportunity cost. If I’m earning an investment return of 3% per year, while everyone else is netting an annual 5%, I’m actually losing money with my portfolio.

And in fact, I would lose real money if I were to trade my 3% coupon bond for a 5% coupon bond. This makes sense: why would someone else sell me a bond for a same bond of a lower coupon rate which results in a lower total value? To buy a bond of the same face value with a higher coupon rate, I’d have to sell my bond at lower price than I had paid for it. You see, the lower coupon rate my bond carries compared to other bonds, the lower re-sell value it has, and hence the more expensive it is to carry. Investors price bonds by resale values: the lower the coupon rate, the lower the price.

Smaller coupons, lower price.

To rephrase the paragraph above, he opportunity cost of bond investment is a higher coupon rate that you could have easily obtained. And coupon rates change frequently. If I buy long-term Treasury bonds, the prevailing interest rate, which closely matches my bonds’ coupon rate, is my major concern. As I illustrated, if the prevailing interest rate goes  up, which means the coupon rate on my Treasury bond becomes relatively lower, my bond’s value declines. If you happen to buy Treasury bonds when interest rate is low, when interest rate goes up, you lose money on your bonds. If interest rate skyrockets, the loss is potentially huge. 50% is possible, and higher than that is known to have happened.

Higher market interest rate results in lower bond prices.

And Treasuries are supposed to be the safest investment vehicle. Hmmmm…

To defend Treasury bonds, other, non-Treasury bonds, have their coupon rates following the same pattern as the prevailing interest rate. Therefore, bonds’ values are highly dependent upon interest rate. Bonds and interest rate move in opposite directions: if interest rate goes up, bonds lose value; if interest rate goes down, bonds gain value. And the longer the maturity of the bonds, the more dramatic the change in value as a result of interest fluctuations.

As you know, currently the yield on Treasury bonds is standing at record low. (Yield is almost synonymous with coupon rate: yield is the value of the coupon payments assuming you reinvest the coupons immediately, so it is a little higher than coupon rate.) If you are buying Treasury bonds right now, you risk losing money when interest rate goes back up. People keep buying Treasuries because they believe interest rate will not go up any time soon. You may follow their thought, or you may think otherwise, that interest rate will go up soon and investing in bonds right now almost guarantees a loss.

The dependence of bonds on interest rate is perhaps the most important thing you need to know about bond investment. I will say this again: bonds and interest rate move in opposite directions, and the longer the maturity, the stronger the impact.

This is my first post on investment. I will continually write on this broad topic as I learn more about ways to invest my money. As usual, should you have questions or comments, please post in the Comments section below, and I will get back to you as soon as I can. Thank you for reading. I hope you have a great weekend!

Best,

Richard

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