Much of the recent bond-buying frenzy has come in the form of investor flows into bond funds, not just individual bonds, and when it comes to U.S. government bonds the difference between owning an individual government bond and owning part of a bond fund is enormous.
Most importantly, a U.S. government bond guarantees a return of your principal upon maturity, but an bond fund that invests in U.S. government bonds does not. The main reason for this is that bond funds generally don’t hold bonds until maturity. Instead, they trade in and out of them, partly in order to maintain their mandated exposure.
For example, a fund billed as a 7-10 year government bond fund cannot be sitting on a pile of originally 10-year bonds which have only two years left before maturity. It will sell its bonds before maturity as they age, and buy fresh ones that meet its mandate.
Because of this, investors can realise substantial losses even on a U.S. government bond fund, even if they hold their bond fund without selling it. This is something we learned a long time ago, personally, when holding a Treasury Inflation Protected Securities (TIPS) bond fund instead of owning actual TIPS outright.
On this topic, Jeremy Siegel highlights the danger of bond investments right now, in his latest rebuttal of those who believe we’re aren’t in the midst of a bond bubble:
Jeremy Siegel: [emphasis added]
Many critics objected to our analogy between high-flying tech stocks and treasury securities. Stocks, of course, have no guaranteed return, while the U.S. government guarantees both coupons and principal of Treasury bonds. This guarantee means that an investor who holds his bonds to maturity will always receive a specified dollar return, quite unlike a stock investor.
But the words “hold to maturity” are critical. Investors are piling into funds that do not hold these bonds until maturity. Funds sell bonds nearing maturity and replace them with similar bonds of longer maturity. That means that if interest rates rise, these bondholders will take a permanent loss on their portfolio.
Here’s where things get nasty. The losses on what many perceive to be low risk investments, thus hold a large quantity of, can be substantial even for small interest rate movements. This is due to the depressed level of bond yields currently on offer in the market:
Interest rates do not have to rise much for Treasury bond investors to realise substantial losses. If, over the next year, interest rates on the 10-year Treasury rise to a level reached last April of 3.99%, the return on the bond is negative 9% (including interest paid). If rates rise to 5.30%, the level reached before the financial crisis, the loss will double to 18%. If the 10-year interest rate rises to the record postwar level of 15.84%, the loss will be 73%, far worse than any bear market in stocks (including the last one) since the Great Depression. All these are computed from the 2.47% rate reached by the 10-year Treasury on August 31.
The potential losses on 30-year Treasury bonds, which are often used to fund IRAs and 401(k) accounts, are much worse. If the 30-year treasury yield, which ended August at 3.52%, returns to its April high, bondholders will suffer a loss of 17%. If yields reach the average level it has been over the past 30 years of 7.3%, the bondholder will experience a price a decline of 50%, equal in magnitude to the worst bear markets in stocks in the past 50 years. For those investing in bond funds, these losses will never be recovered unless interest rates return to current levels.
Again, to put these potential losses in context, note that A) they just require a small back-track in interest rates, just back to April levels, and B) many investors hold vastly larger quantities of money in bonds than stocks under the assumption that they are low risk, thus even a 10% loss can be devastating to a portfolio.
Finally, Mr. Siegel reminds us how hoping to jump out of bonds before interest rates rise is a fools game:
Oh, were it only so easy! Traders in Treasury bonds do not wait for Fed announcements. Well before the Federal Reserve raises the Federal funds rate, long-term interest rates will have risen and the price of Treasury bonds will be down. In fact, if we get a string of even moderately strong economic news over the remainder of this year, we will see the 10-year Treasury yield well above 3% by December, imposing substantial losses on current bondholders.
Similar to housing investors who hoped to jump out before the market collapsed, or Dot Com investors who wanted to sell high-priced stocks before the crash, most people will fail. What makes the situation more worrying than a stock bubble is the fact that the majority of retirement assets is in bonds, and investors have shifted heavily out of stocks and into bonds over the last few years. Mr. Siegel is recommending high dividend stocks with stable dividend payment histories that earn profits that comfortably cover their dividends, which we tend to agree with, but…
Worst case, if you are adamant about owning U.S. government bonds, then own actual bonds rather than a government bond fund. Then should interest rates rise, you can at least choose to hold your bonds to maturity should interest rates rise, and assure the value of your bond principal. Better yet, own the inflation-protected government bonds known as Treasury Inflation Protected Securities. Then you can hold your bonds to maturity and assure both your principal and some protection against inflation, even if interest rates go the wrong way.
Just steer clear of government bond funds with the money you need to be ‘risk-free’.