Friday, April 15, 2016

Dangerous Investing in Bonds ... Today's 'Duration Risk' in Bond Investments Is Both Real and Huge

Bonds are incorrectly viewed by most individuals as safe investments. And here's something else that makes bond investing hazardous to one's financial health and well being --- the longer the bonds will be outstanding (the duration), the bigger will be the interest rate and credit risk undertaken by the lender.

And that duration element in order to get a marginally higher interest rate simply isn't a risk I'm prepared to take in the historic low rate environment of today. Nor should you, I would suggest.

For an example of how interest rate risk works, think of a chart with a slanted line going from the lower left to the upper right. The vertical axis represents the rate of interest and the horizontal axis represents time or duration of the bond. The longer the duration or the longer the bond is outstanding, generally the higher the interest rate that will be paid on the bond. So far, so good.

But now let's think of a Teeter Totter (see my recent post on this) with the future of interest rates going up over time and the principal value, aka price, of the bond going down. That's the situation facing bond investors for the foreseeable future. The farther investors go out on the yield curve, the more interest rate risk they are taking with respect to future interest rate levels. And the more interest rates rise, the farther the price or principal value of the outstanding bond will fall if not held until maturity. It's really just that simple.

{NOTE: Of course, there are other risks to consider as well, such as credit risk, for non-government entities and even some government borrowers as well. If a company or government agency enters bankruptcy, bondholders have a higher claim on the assets than do common stock investors, and if a company decides to stop paying dividends to its owners, it can do so, unlike its obligation of making principal and interest payments on its bonds. That said, individuals need not and should not invest their savings in a risky stock which may not be able to make its payments, whether they be on the company's outstanding bond obligations or to its shareholders in the form of cash dividends.}

So that's precisely why I've chosen to buy for the long haul shares in good blue chip companies, participate in growing dividends and enjoy a growing share price over time.

But if you're going to buy bonds in a low interest rate environment such as today, and in all probability tomorrow as well, please take the time to know what you're doing and don't 'reach' for yield by buying long dated bonds of companies which aren't blue chip investments.

Duration Risk: The Bomb Ticking Inside Today's Bond Market contains valuable information about the riskiness of bond investing for individuals:

"{There is} a quiet risk suffusing bond markets in the era of low and negative rates: duration.

The duration of a bond is a measure of when an investor gets his or her money back. Longer-term bonds have higher duration—as do bonds with lower coupon payments, because low coupons mean more waiting.

Today, with global interest rates extraordinarily low, and borrowers issuing ultralong debt, duration is shooting up.

Duration implies risk: A rule of thumb is that a one percentage-point change in interest rates implies a change in the bond’s price equal to the duration. A bond with a duration of 25 years will jump 25% if interest rates fall by one percentage point ​and fall 25% if rates rise by the same amount.​ . . .

As durations get longer, risks mount. . . .

That long waiting period is worrisome.

An educated investor can take a guess at where interest rates might be in two or three years and the situation that the economy might be in then. That is the sort of range that many central banks and other large institutions attempt to forecast across, and many end up being inaccurate. A forecast of the world in four decades is a fool’s errand.

Usually, to account for duration risk, the yield curve on bonds is relatively steep. That means bonds with long maturities have considerably higher yields, since an investor is facing considerable uncertainty. . . .

But institutions which have made government bonds the backbone of their business model, like insurance companies and pension funds, may struggle to find safe alternatives with a similar yield.

Those investors and fund managers are forced to take on more risk. When that is through credit risk, as in the case of Venezuelan government bonds, it seems obvious to everyone. When they are loading up on bonds that don’t mature for longer and longer periods, it is less easy to see. But the risk is still there and growing."

Summing Up

For my personal account, I don't own bonds and have no intention of doing so. Rates will be higher down the road as far as the eye can see, and that's not good for bond investors. It's the Teeter Totter effect at work.

Instead I own shares in blue chip dividend paying and growing companies, and I own them for the long haul.

In my view, that's both the safest and most profitable way to invest my savings.

You may wish to consider a similar approach. 

But whatever you do, take the time to know what you're doing with your money. It's very much worth the effort.

That's my take.

Thanks. Bob.

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