Almost overnight, bonds have become the new haven for people looking for safe investments. But this much ballyhooed investment may not offer all the safe harbor you think it does.
A look at the allure of bonds
It’s almost an automatic with human behavior that so many people zig when they should zag. If you go back to the bubble in tech stocks, people believed that values would just keep going up and up. At the time there were daily news reports about this or that tech stock that opened at $20 and closed at $300 after a day of trading. The NASDAQ went to a composite value of 5,000. Then, suddenly, the bubble burst and values fell.
Following the tech bubble, we had the housing bubble. And now we’re in the newest bubble — the bond bubble. The financial press is all abuzz about bonds, which are essentially where you act like the bank lending money to businesses and different levels of government.
People are always looking for an easy score or the safe zone. Stocks tripled in value since the low of 2009, which has led a lot of people to expect another big decline in value around the corner.
That’s led small-time individual investors to become convinced that bonds are neutral territory, tucked safely out of the line of fire from the volatile stock market. The problem, however, is that most people who buy bonds don’t know how they work.
Remember the seesaw analogy
Say I own a bond paying 2 percent interest. Then let’s say interest rates go up to 3 percent. Suddenly, my bond becomes worth less. Why? Because if I want to sell, a buyer isn’t going to want to buy it a price that earns them only 2 percent. They want to buy at a price that earns them 3 percent. So that means I have to discount my bond to the point that the buyer gets the equivalent of the current interest rate by buying my bond on sale.
It’s like a seesaw. As interest rate rises, the value of bonds goes down. If rates drop, then bond value goes up.
Does that mean you shouldn’t own bonds? No. I own tax free municipal bonds through bond funds. But they’re part of a diversified portfolio. I tend to buy shorter term bonds. Most of mine have terms left of around 6.5 years. So I have some interest rate risk, but not a great amount.
The reality is that interest rates are at historic lows right now. But it won’t always be that way. The danger is much greater that you’ll get your clock cleaned thinking you’re going into a safe zone buying bonds than you would taking your chances in the stock market — provided you’re talking about long-term money that you won’t need until retirement.
If you’re that terrified of stocks right now, don’t do bonds — buy CDs or savings accounts instead. The principal is secure and the account is insured by the FDIC (or NCUA for credit unions). You want to avoid the hurt that bondholders will feel when today’s puny interest rates eventually do turn.
Finally, one different piece of advice for a small segment of listeners who earn more than $250,000 annually: For you, shorter-term municipal bonds remain a good deal in today’s market.