How Bonds Can Bite
Bonds are safe, right? Not so fast. Prices are high—and so are the risks.
Check out our five-step protection plan By LYNN BRENNER
In 2009, investors poured a whopping $400 billion into bond
funds, seeking refuge from the worst stock-market implosion in
decades. That’s understandable, given that bonds—essentially
IOUs that promise fixed annual interest payments—are generally steadier, more predictable investments than stocks.
But the flight to safety in a
shaky economy has, ironically,
made bonds riskier. Huge
demand has driven up prices,
and when bond prices rise,
bond yields slip—and investors
start taking more chances.
The Next Bubble
Here’s the situation: Imagine a $1,000
bond that pays 4 percent interest,
meaning its annual payment is fixed
at $40. If the price doubles to $2,000,
that $40 becomes a 2 percent yield—
and who would be satisfied with that?
Rising prices prompt investors to
hunt for bigger game—riskier bonds
and bond funds—to maintain their
income. And like homebuyers who got
in at real estate’s peak, bond investors
who pay the highest prices will suffer
most when the bond bubble bursts.
Today bonds are much more expensive, yields are much lower ( between 2
and 4 percent for the safest corporate
bonds), and risk is much higher—yet
demand keeps inflating the bubble.
“The biggest mistake bond investors
are making,” says Eleanor Blayney,
consumer advocate for the Certified
Financial Planner Board of Standards,
“is to ask only what they can earn, not
how much risk they’re taking.”
The Interest-Rate Threat
Bonds always carry three kinds of
risk: default risk, inflation risk, and
Default risk is easy to understand.
As a bond investor, you’re a lender. If