Wednesday, September 22, 2010

The Bubble In Bonds Part 2 - How To Invest More Safely

This is Part 2 of a 3-part series about bonds.  In Part 1 of this series, we discussed that while bonds are generally believed to be "safe", they some bonds may actually lose 40%+ of their value in a rising in a rising interest rate environment - and from our current historically low interest rates, interest rates have no where to go but up.  In Part 2 we will discuss some ways to invest more safely in bonds so that when interest rates rise and the current bond bubble bursts, you are not faced with worse losses than in the 2008-2009 stock market decline.

How to Invest More Safely In Bonds
As the example in Part 1 illustrated, for safety go with a shorter duration.  Many people see that the yield of the 30-year bond is greater (3.875) than then one-year bond (0.24) and go with the 30-year.  That's OK if you know what you are doing and appreciate the investment and its risks.  However, I think that a lot of people are investing in those 30-year bonds because "bonds are safe."

Well, these are the same people that bought real estate at the height of the market - and now they are buying bonds at the height of the market.  They are going to get burned again because they don't appreciate the fundamental valuation of the asset they are buying and they don't understand how the asset will function.  Further, they are buying based on past performance when it is clear that we are in an unprecedented time.  The people that are buying 30-year bonds because "bonds are safe" are the same ones that bought second and third homes during the real estate boom because "real estate is safe and never goes down."

In fact, some real estate purchases - like some bonds - are safer than others.  And some bonds are pretty "safe", such as those with shorter durations.  However, investors can lose money in bonds - and are going to lose a whole lot of it when interest rates rise from their historic lows.  Investors need to appreciate that although the 1-year bond and the 30-year bond are both "bonds", their risk attributes are very, very different - it's the difference between losing 3% vs. losing 40% in our example.

Also, I would seriously be concerned about default risk (the bond issuer does not pay as agreed) outside of US federal government bonds.  For US bonds, the government will not default because they just have to print more money.  That will cause huge inflation (which would be bad for the economy), but they won't default.  However, for municipalities and state governments that can't just print money, the situation is more dire.

States and municipalities are going to be faced with the harsh decisions of drastically raising taxes, drastically cutting benefits (like pensions), or defaulting on their municipal bonds.  Unfortunately, from the point of view of an irresponsible elected official that just cares about getting re-elected, screwing the bondholders is probably the most politically viable option.  We have already seen a number of defaults, but I think that that number is very likely to grow - especially as more pension payments come due in the next few years.

Personally, I got out of municipal bonds in 2008 and I really don't see myself going back there anytime soon.  Frankly, I am amazed that people are currently risking any of their dollars in that market.  I think that they still have old-fashioned views that the bond issuers (states and cities) value honesty and doing the right thing instead of just enriching themselves and keeping themselves in office.  I think that the investors in the munis are the same ones that gave money to buy mortgage notes - because they believed that people would not default on their homes. (Obviously some defaults are involuntary, but there seems to be many voluntary defaults these days.)  The same investors who loaned people money to buy homes and are getting burned seem to be the ones that are loaning money to state and local government - and are probably going to get burned again.

Here's why - I don't think that they realize the extent of the cultural shift that has gone on.  For example, 30 years ago it would be inconceivable that anyone would walk away from a mortgage - that was your home!  It didn't matter if you were "underwater" - you made the deal and you were going to keep it.  Your honor and responsibility were at stake.  Sure, sometimes events made it impossible, but people that did not keep their world were quite literally shunned.  Losing your home to foreclosure typically meant that you were a bad person and there was something wrong with you.

Conversely, now we have people that simply walk away from their houses because they feel that the house is no longer a good "investment" - and unfortunately there are no repercussions.  They can afford to pay - and they promised to pay by signing the mortgage - but they just don't feel like it because it will take too long in their minds to get back to their purchase price.  Wow.  Just wow.  Unfortunately, we no longer have any consideration for the loss of the person that loaned them the money.  30 years ago, your loan was most likely made by a local bank - and if you defaulted it meant that you were screwing over your neighbors (who put the money in the bank in the first place), who were typically very unhappy with you and might tell you to your face things like what scum they thought you were and how you were damaging the community.  Seriously.  You would be an object of ridicule and scorn.

That's pretty much unimaginable today where money for the loans just seems to just come out of the aether and people default at the drop of a hat - and without any consequences or anything close to the pressure that used to be put on people.  Unfortunately, we have lost track that the money the defaulters are costing us is still coming from somewhere - it's not just a magical loss with no consequences.  It's coming from our diminished pension funds, our lowered stock market returns, and the potential increase in costs that we will most likely soon be experiencing.  Most of all, it shows up in the massive and rapidly accumulating federal debt.

It seems pretty plain that states and municipalities are going to take their cue from the housing bubble.  There is not going to be a lot of concern for the loss of money that accompanies the default - and there hasn't been in the few default cases.  The damage is too abstract - the connection to everyone's finances is too tenuous.  The bondholders will be characterized as "fat cats" that need to "do their share" to "pitch in in this difficult economic time."

But I digress.  In short, municipal bonds have a default risk that I think is far, far huger than the market is currently valuing them - and I don't think that they are a safe bet by a long shot. 

With regard to corporate bonds, I find that there are actually some reasonable bargains for high-quality corporate bonds.  Here you want to make sure that the underlying corporate operations are less interest-rate or economy dependent - and still go with shorter duration bonds so that you don't get crushed when interest rates inevitably rise.  I think that the default risk for corporations is probably much more reasonably understood than the default risk for munis - and is more accurately represented in the price.

Finally, sometimes people think that if they just buy a bond and hold it to maturity (never sell it), then they are free from interest rate risk.  They can never lose!  However, that's like buying a stock and then when the stock goes down claiming that you have not lost money because you have not sold the stock - it's not reality - the market valuation has changed.  Sure they get back the par value at the end, but they have lost out because they locked in a lower rate of return than what they could have gotten.  They are still subject to inflation risk - for example, even though they are getting paid at say 3%, inflation could go to 5% - for them to say that they are not taking a loss in that situation clearly makes no sense.  In summary, holding the bond to maturity does not eliminate the loss- just spreads it out.

So in summary, to invest more safely in bonds, realize that interest rates are at historically low levels that have never before been seen - they have no where to go but up.  Further, as interest rates rise (and they can rise a lot from these levels) bonds values are going to be placed under tremendous pressure.  That's going to crush the market values of longer term bonds - and even shorter term bonds will still be hurt.  However, the shorter the term, the less damage.  Additionally, avoid munis because of increased default risk - look to high-quality, shorter-term corporate bonds for value.

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