Taking a Second Look at Bonds Should Worry Investors

Inflation and interest rate risks remain a major concern, and here's why

    View All  

Taking a Second Look at Bonds Should Worry Investors

If you remember bond drives in school, please raise your hand. There are still a lot of us out there. I recall my teacher holding up a US Savings Bond, encouraging us to tell our parents to buy them. She went to great lengths emphasizing that they were the “the safest investment on earth.”

That same teacher gave us ten new words each week that we had to spell and define. “Safe” and “risk” both had their day. Here is how Merriam-Webster defines them:

safe

adjective sāf

: not able or likely to be hurt or harmed in any way : not in danger

: not able or likely to be lost, taken away, or given away

risk

noun risk

: the possibility that something bad or unpleasant (such as an injury or a loss) will happen

Safety is the absence of risk. When we lived in Texas, we had to take our cars in for a safety inspection. The inspector would hook up a computer and out came a checklist of items with a pass or fail mark. It’s time to do a safety inspection for those high-quality bonds considered “the safest investments on earth.”

Risk #1: Default. The risk that a loan won’t be repaid is the primary risk when lending money to anyone. When it comes to bonds, rating agencies judge that risk for you. The safest way to lend—in terms of getting your money back, anyway—is with federal government bonds or certificates of deposit, which are federally insured.

Corporate bonds are rated with a series of letters beginning with AAA. Anything below the B-ratings are generally not considered investment grade and are commonly referred to as junk bonds. If an investor sticks to AAA bonds, they will earn a little higher interest than they would with US Treasuries to make up for the increased default risk; however, that risk is very low, generally less than 0.5%, on average.

A person buying a US government bond or AAA corporate bond has close to a 100% probability of being paid back with interest. Check off the first item on the inspection sheet. PASS!

Risk #2: Inflation protection. The interest rates paid by a bond (net after income taxes), must be higher than the inflation rate throughout its life. If not, when our principal is returned and added to the interest received, our buying power will be less than it was before we bought the bond. How big of a risk can that be?

In a recent article, we looked at the high inflation during the Carter administration. We took a hypothetical investor who bought a $100,000, 5-year, 6% CD on January 1, 1977. He was in the 25% tax bracket. At the end of five years, the balance on the account was $124,600. While it sounds like more money, his buying power had actually dropped by 25.9% because of inflation.

If, on January 1, 1977, a luxury car cost $25,000, he had enough to buy four of them. Assuming the price of that car rose with inflation, it would have cost $37,500 five years later; he would have had enough for just three with a little gas money left over. I realize no one needs three or four luxury cars, but you get the picture.

Inflation feeds the illusion of wealth, but it is just that: an illusion. If your retirement nest egg does not keep up, you are getting poorer by the day. This is called “negative real rates.”

Losing ground to inflation happens with high inflation and/or very low interest rates. The following chart shows the ten-year Treasury rates compared to the inflation rate and the net yield to the investor after taxes (assuming 25% tax rate).

TaxesandInflationNeuterTreasuryYields Taking a Second Look at Bonds Should Worry Investors

Unlike the days when bonds paid 6% or more, since 2010, low-interest, 10-year Treasuries have not kept up with inflation. Currently, 10-year Treasuries are paying 2.77% and 30-year issues are paying 3.80%.

We need to red flag this one. The “safest investment on earth” is a surefire loser for seniors and savers. Do you want to invest your money for 10 to 30 years in Treasuries knowing you will lose buying power to inflation the minute you buy them, and possibly lose even more in the future? Obviously not! FAIL.


Article printed from InvestorPlace Media, http://investorplace.com/2014/02/second-look-bonds/.

©2014 InvestorPlace Media, LLC

Comments are currently unavailable. Please check back soon.