Monday, September 20, 2010

The Bubble in Bonds Part 1 - Appreciating Risk In Bonds

We know all about the bubble in stocks in 2000 and the more recent housing bubble, but many people don't seem to recognize that we are in a huge bond bubble right now.  However, a few people seem to be catching on - see this post and this article.  The bubble in bonds can be really dangerous because many people seem to associate "bonds" with "safety" and fail to appreciate that there is a huge difference in risk between bonds - even bonds issued by the same issuer just having different maturities.  In this series, we will discuss 1) some ways people fail to appreciate risk, 2) how to invest more safely in bonds, and 3) other bond-like instruments to consider that may be safer than bonds.  Part 1 of this series starts below.

First, a brief review of how bond pricing works.  The price of bonds varies inversely with interest rate.  For example, assume that today someone will give me a bond at $3/year for my $100.  However, next year the market rate is paying $6/year for $100.  I now want to sell my bond that pays $3/year - what price will I get?  Well, a person who approaches the market today can get $6/year in exchange for $100 and is not going to buy my bond unless I give them the same rate of return.  That is, I will have to cut the price of my bond from $100 to $50 - so that the person buying the bond will be making 6% ($3) on their $50 purchase rather than 3% ($3) on their $100 purchase. 

As you can see, bond prices are can be highly volatile with interest rate.  In the example above, the bond literally lost 50% of its value due to the doubling in interest rate.  So why are bonds generally regarded as safer and less volatile?  Two reasons:  First, we have not has such huge interest rate volatility in the recent past, so people are unprepared for it.  However, we are currently at unprecedentedly low interest rates - which means that once interest rates recover (rise to normal level), they will be rising more than they ever have previously and the commensurate decline in bond values will also be unprecedented. 

Second, the term of the bond lowers its volatility.  Here's how.  In the example above, the bonds have infinite term.  Consequently, they respond only to interest rate fluctuations.  However, in the real world, bonds only lock up your money for a given time - and then you are free to invest at the new rate.  Consequently, the decline in value is not based on an interest rate loss for all time - just for the limited time until the bond expires.

Consider the example of a person who buys a one-year bond at 3% for $100 and the market immediately moves to 6% the next day.  (Sure, it's not realistic, but it's an example to make a point.)  The person is entitled to a total payment of $3 for the year that they own the bond  - and then they get their $100 back.  However, a person buying the bond the next day would be entitled to a payment of $6 over the year - and then they get their $100 back.  The total difference ($106-$103) is $3.

Consequently, if I sold my 3% bond today for $97 instead of the $100 I bought it for, then at the end of the year the purchaser would get back the $100 plus the 3% interest - and they have made $6 that they would have made buying the new bond at 6%.  (The would actually have done a little better than 6%, but this is complicated enough already).  Thus, because of the short 1-year term, when interest rates double the value of my bond only goes down by 3%.

Unfortunately, if the term of my bond is 30 years, as many bonds are, the decline in price would be much greater.  The actual calculation gets pretty complicated.  However, for the 30 year bond, the doubling in rate causes the value of the bond to fall from $100 to about $59 - about a 40% loss..

Consequently, many people investing in "bonds" are probably investing in longer-term bonds that are significantly exposed to interest rate risk.  These "safe" investments may very well lose 40% of their value or more when interest rates rise from their unnaturally low levels.  There is a very significant risk here that does not seem to be appreciated because bonds are "safe".  Unfortunately, bonds are "safe" in much the same way that real estate is "safe" - and we all know what has happened with real estate over the last few years!

In Part 2 of this series, we will take a look at how people can invest more safely in bonds.

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