Bond Risks and How to Beat Them
by Jeremy J. Siegel
Friday, September 17, 2010
The op-ed piece The Great American Bond Bubble that I published on August 18 in The Wall Street Journal with Jeremy Schwartz, Director of Research at WisdomTree Investments, attracted both attention and controversy. That is what we wanted. We claimed that, at today's prices, investors in government bonds would regret their purchases just as investors in stocks did at the top of the technology bubble a decade earlier. At the height of that bubble, investors paid an unprecedented one hundred and more times earnings for large companies, a price that was bound to disappoint. Today's investors are paying 100 or more times the one-year's return on a 10-year TIPS (Treasury Inflation-Protected Security), a price which we also believe will lead to substantial losses.
We also believe that investors have some serious misconceptions about bond funds they are clamoring to buy. Many assert that Treasury bond funds are safe because the principal and coupons are guaranteed by the US Treasury. Furthermore, although they concede that interest rates will rise eventually, they believe they will have time to get out of their bond funds before prices drop significantly. These misconceptions will cost these investors a pretty penny.
Treasury-Bond Funds Don't Guarantee Principal
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.
Interest rates do not have to rise much for Treasury bond investors to realize 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.
Why Rates Will Rise
Several analysts did not think current long-term rates were unusually low. Tony Crescenzi, a market strategist and portfolio manager from Pimco, noted that, if inflation runs at about 0.5% over the next 12 months, as they forecast, the real yield on 10-year treasuries will be just about 2%, in line with their historical estimates.
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