With the stock market reaching record highs, housing prices firming up and the economy continuing to recover, optimism appears to have swamped concerns over the fiscal crisis, at least for now. But all that has not quieted observers who fear the bond market is a bubble that will ultimately burst, and economic recovery may actually hasten the burst.
Bonds are typically seen as less risky than stocks for several reasons. First, bonds carry the promise of the issuer to return the face value (the stated value of the bond when issued) to the bond owner on a specified maturity date; the value of stocks is driven by the market with no termination date or promise of repurchase from the issuer. Second, most bonds pay a fixed rate of interest on the face value; stocks may pay dividends but there is no obligation to do so and those dividends can be changed. Finally, while it can certainly go up and down, the overall bond market has historically been less volatile than the stock market.
Three recent trends have contributed to the overall risk of bonds. First, we are at the end of a 30-year plus trend of falling interest rates, leaving rates with not much farther to fall. Second, the “quantitative easing” policies of the Federal Reserve, (in other words, injecting money into the economy to spur growth) has added huge demand for certain types of bonds. Finally, investors who rely on their portfolios for income have been forced to invest in areas with which they are unfamiliar because the income from more simple, traditional vehicles is so low.
As with all investments, bonds have a long array of risks, and some are quite technical and esoteric. Here is the current status of three of the most significant risks of investing in bonds.
Default risk is quite simply the risk that the bond issuer is unable to pay either the interest payments or the face value at maturity. While default can result in the greatest loss to the owner of an individual bond, it is also the least likely to occur.
The financial crisis of 2008-2009 created fears of widespread defaults, with some firms failing and others needing government bailouts. Indeed, corporate bond defaults spiked in 2008 and 2009, peaking at 5.4% of all corporate bonds worldwide rated by Moody’s, one of the major credit rating agencies. Bonds that are rated as speculative (commonly known as “junk bonds”, or bonds that are rated as less likely to pay interest or principal) defaulted at a 13.1% rate in 2009.
By 2010, however, default rates had plummeted, falling back down to 3.2% for junk bonds and 1.3% for all bonds. Low interest rates, support of the financial system by the Federal Reserve and severe cutbacks by companies made it much easier for companies to make their bond payments. Still, lower quality bonds pay higher income and investors have flocked to these bonds, raising prices to historic highs compared to the benchmark 120-year Treasury bond.
Corporate bonds are not the only version that risks default. Some analysts project that municipal bonds, issued by state and local governments, will see more defaults as their debt problems grow. Municipal bond defaults have historically occurred in bonds issued for revenue-generating projects that are not viable, particularly in housing and healthcare. And the recent bankruptcy of the city of Stockton, California further illustrates the risk of municipal bond default. Even Treasury bonds could conceivably default if government debt continues to grow or even sooner if Congress fails to extend its borrowing capacity.
Default risk can be reduced by owning a variety of bonds or, more simply, buying a diversified bond mutual fund.
Market risk is the basic principle of supply and demand applied to the broad bond market. If investor demand is high, market prices will be supported and likely go up. If investor demand falls, the market as a whole will decline regardless of the fundamental merits of the individual bond or bond type.
Low interest rates have to some extent driven investors to abandon bonds in search for higher income. On the other hand, the two significant stock market declines since 2000, and the fear of another decline, have kept investors buying bonds.
The wild card is the significant purchases of government and mortgage-backed bonds by the Federal Reserve. (The Bank of England and European Central Bank have also been big buyers of European government bonds, and the Bank of Japan recently announced a bond buying program.) These bond purchases are intended to inject money into the economy, keep interest rates low and spur growth but they also pump up the bond market. The Fed has increased the amount of securities on its balance sheet from under $900 billion in August, 2007 to $2.9 trillion currently. Last fall the Fed began buying $45 billion of Treasuries monthly in addition to the ongoing $40 billion monthly of mortgage bond purchases, which will eventually take their total to $4 trillion.
When the Fed ends it bond buying programs and eventually begins selling the bonds it owns, the bond market will surely suffer. There will be far fewer bond buyers, and these buyers will demand higher yields and lower prices. The Fed has indicated its intention to keep interest rates low until unemployment goes below 6.5% or inflation goes over 2%, but there is already speculation that the Fed may end its bond buying sooner rather than later.
Interest rate risk is the inverse relationship of interest rates and bond prices – when interest rates fall, the market price of bonds generally rises, and when interest rates rise, the market price of bonds generally falls. This happens because investors are comparing bonds that were issued earlier to new bonds that are issued at the current rate, and adjusting market prices to equalize their investment return. And with interest rates so low for so long, the growing risk is that they will have to go back up at some point.
The longer a bond’s maturity, or the average maturity of the bonds in a mutual fund, the greater is the change in price for an equal interest rate change. A measure known as “duration” gives a more accurate indication of how prices will change with interest rates, and duration can be compared to the interest earned to gauge interest rate risk. For example, an index of the overall government and investment grade bond market has duration of 4.78 (the price will change by 4.78% for every 1% change in interest rates) and a yield of 1.75%. An index of the short term bond market has duration of 2.69 (the price will change by 2.69% for every 1% change in interest rates) but a lower yield of 0.63%. Investors get paid less (lower yield) for less risk (lower duration) and have to decide for themselves whether they are being paid properly for the level of risk they are assuming.
Both interest rate risk and market risk can be largely avoided by owning individual bonds and holding them to their maturity dates. As long as the bond issuer does not default, the bond will pay its face value at maturity. However, interest rate and market factors will still affect the current market value of the bond shown on periodic statements and can lead investors to feel they have suffered losses, even though those “losses” are only realized if the bond is sold. Bond funds do not have a maturity date and so there is no specific date at which the fund will repay investors, making bond price changes more difficult to avoid.
These risks do not mean that bonds should be avoided or abandoned; all investments have a long litany of risks. It is impossible to accurately predict exactly when and how significantly these risks may come to fruition. Bonds still have a place in a long-term diversified portfolio but investors should be aware of the potential risks so they can manage them accordingly.