Bonds #1: Bracing for the Crash

The editors of the paper select the headlines for this column. Each week I suggest a headline and each week they tend to ignore my suggestion and use one of their own. For this article I suggested the title: “Bonds: Bracing for the Crash.” It is a bit of sensationalism, but since you (probably) won’t see it at the top of this column, I thought I would share my crazy title idea.

This time, I would completely agree with tossing my title. After all, I don’t actually think that there is an impending crash in store for the bond market. Yet a lot of folks do, and just about everyone who is involved in this part of the market agree that the 30-year bull market in bonds is over.

First, a refresher. Back in the early ‘80s the United States was experiencing very high inflation and with it very high interest rates. Getting 10% or more on a CD was not just possible, it was the norm. These days most junk bonds pay less interest than that risk-free CD used to. A couple percent return is about all you can hope for today. That is what caused the 30-year bull market in bonds.

You see, bond values move in the opposite direction of interest rates. If interest rates go up, bond values go down. If interest rates go down, bond values go up. The reason makes sense if you think about it. If you are holding a bond that pays 4% in interest, and interest rates change so that an identical bond is being sold that pays 5%, why would they want to buy your bond? The only way to make your bond attractive to them is to lower the price for that bond to the point that its equivalent yield equals 5%.

Just how far down can bonds go if interest rates go up? That depends on a number of factors, but there is a shortcut you can use. It’s called “duration.” While not a perfect measurement, duration gives a good approximation of how far a bond price will go up or down if interest rates move 1%. For instance, if you have a bond or a bond fund with a duration of 8, then if interest rates move up by 1% the value of that bond or bond fund will move down by 8%.

And with interest rates hovering at historic lows for the last few years, no one doubts that the next big move is up (which means down for bonds).

There are two reasons why most bond holders own bonds: Income and Safety. Income has been decidedly lacking lately due to the Federal Reserve’s program to stimulate the economy through low interest rates. Safety is the predominant rallying cry these days, especially after what happened to stocks and real estate during the financial crisis. But with the potential for losses—losses that could easily wipe out any interest earned, and then some—it might be time to look for an alternative to bonds.

We’ll start looking at that next week.

This article was published under the title "Bonds in Limbo: How Low Can You Go?" in the Wichita Falls Times Record News on July 14, 2013.