Perhaps the “safest” bond of all for American investors is the US Treasury bond. If for no other reason than the government can just print more money to repay the bonds at maturity and/or the interest along the way.
But even these bonds do not fit into my clients “safe and secure” bucket where their investments can never go down in value. In this bucket their money can never go backwards. You can watch a 60 second video on the 3 buckets of risk by clicking the link at the bottom of this blog post.
So lets take a quick look at the US Treasury 10 year bond.
On January 30th, the yield on the 10 year Treasury was 1.64%. So if you bought $10,000 of them on that day, you would get to “enjoy” a 1.64% annual return over the next 10 years and then the bonds would mature and you’d get your $10,000 back from Uncle Sam.
Let’s forget for the moment what $10,000 would be worth in inflation-adjusted dollars ($7,441 at just 3% inflation). You “safely” lost over $2,500 in purchasing power.
Anyway, let’s say you had to or wanted to sell your bonds today (Feb. 18) because you found something better to do with your investment dollars or the kids needed a “loan”.
Those “safe” $10,000 of bonds that you bought less then 3 WEEKS ago are now worth just $9,561. That’s a 4.39% loss in 19 days! By the way, the risky stock market was up about 5% during the same time. But it could just have easily lost -20% too.
What happened? Interest rates on the 10 yr have risen to 2.13% as of today. And they may move higher over the next year. And higher still over the next 4-5 years. Each rise in interest rates makes your investment worth less. And the loss of value is even more pronounced with bonds that have longer maturities.
Why does this happen?
Well, if your neighbor was looking to buy $10,000 of 10 yr Treasuries today, would they want your 1.64% interest rate or the 2.12% that is offered today? The answer is clear. So the only way someone would buy yours, is if you discounted it to yield the same 2.13%. Hence the value of only $9,561.
The moral of the story is that bonds do NOT belong in the “safe and secure” bucket. That “no-loss of principal” bucket is reserved for CD’s, savings accounts, money market accounts, T-bills, and in this low-rate environment my favorite…. guaranteed fixed and indexed annuities. They offer higher guaranteed and/or potential interest rates as well as many other tax and other benefits.
So what investment bucket should bonds go in? That’s a good question. Depending on the type of bond, it may belong in the moderate risk… or even high risk investment bucket. And always keep in mind the potential loss of purchasing power due to the adverse effects of inflation.
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Here is the link to the 1 minute YouTube video on the 3 buckets of risk: https://www.youtube.com/watch?v=ZnkNHCwNsBc
all the best… Mark