The plain fact is that bonds are not safe investments. In fact, they will do more harm than good to your investment "health" for years to come.
Here's how the simple story of simple math unfolds. Interest rates are low. Over time they will increase. As they do, bonds will become worth less. Their total return won't even offset future inflation. That's just the way the math of bond investing works.
Thirty years ago buying thirty year maturity bonds was a good investment decision. Today anything longer than thirty days is likely to be a bad investment choice.
What this has to do with public pension funding is simple. If the average fund assumes an investment return of 7%-8% annually and if the average portfolio is 40% or more invested in bonds, and the if the average bond returns 0%-3% at best over the next several years, there is no way the typical blended portfolio mix in total will earn 7%-8%. That is, unless stocks return 12%-14% annually on average, which they won't.
As an example, Illinois claims to have a $100 billion underfunding problem with public sector pensions. Truth be told, it's probably closer to $200 billion or higher. Other plans have the same problem.
That all means taxpayers are in even greater jeopardy than commonly believed throughout America. In turn that's not good news for economic growth as higher taxes beget slower growth and higher unemployment. It's a vicious circle.
For why public pension funding is an issue that will be with us for a long time, please read on. It's not a pretty picture.
If You're a Bond Investor, Beware of the Seesaw has the story:
"THE Securities and Exchange Commission issues frequent bulletins about what it calls “investment frauds and scams” — a frightening taxonomy of plots and stratagems aimed at separating investors from their money.
The agency’s alerts range from warnings of Madoff-style Ponzi schemes to “pump and dump” operations intended to temporarily inflate a stock price. They also include cautionary notes about polite offers of assistance from predators posing as government regulators.
Lately, though, the S.E.C. has been giving a warning of a different sort. Bearing the general title “Interest Rate Risk,” this latest bulletin is a cry for understanding. It’s about bonds, and for most people, the subject is confounding.
The problem isn’t a new scam but a lack of knowledge about how bonds work, which can be dangerous in a time of rising interest rates. In its bulletin, the agency points out that investors need to understand that when rates rise, bond prices generally fall. This inverse relationship is a fact of life in the bond market. Like gravity in the physical world, it’s constant, powerful and important.
But outside trading floors, business schools, banks and brokerage firms, bond dynamics are fairly obscure, surveys find. That’s troubling in a time like this, said Lori Schock, director of the agency’s Office of Investor Education and Advocacy. “We’re not predicting what’s going to happen to interest rates or when,” she said, “but we do know that rates can’t go much lower. And we know that they can go a lot higher.”
If interest rates do go higher, most people don’t understand how that will affect bonds. A 2012 financial literacy survey by the Finra Investor Education Foundation asked this question: “If interest rates rise, what will typically happen to bond prices?” Prices will fall, but only 28 percent of adult Americans in the survey answered correctly. Finra ran the same survey in 2009 and got the same results.
The Finra survey found that financial literacy levels were generally very low. On its Web site, it offers a five-question quiz, with questions drawn from the survey — none requiring computations, just an understanding of basic concepts. Only 14 percent get them all right, it says. (The average number of correct answers is between 2 and 3.)
As far as bonds go, Ms. Schock said, one way to visualize the relationship of interest rates and prices is to think of what she calls “a teeter-totter.” She’s from Indiana. In Queens, where I come from, we call it a seesaw. Whatever you call it in your playground, imagine interest rates sitting on one side of a plank and bond prices clinging to the other. When one side rises, the other falls.
That’s just the way seesaws work, and it may be enough explanation. But suppose you want to go a little deeper: Why do interest rates and bond prices move like this?
Here’s one way to understand it: When you buy a fixed-rate bond, you are making a loan. In return, you get your money back, plus interest. When market interest rates rise, the bond drops in value. That’s because, under current conditions, anyone making the same loan will expect more interest than you’ve gotten. If you want to trade the old bond for a new one, the old one will have less value. And when something sold in the marketplace has less value, its price usually falls.
There are exceptions to every rule, of course. If the bond’s interest rate isn’t fixed, and instead readjusts as market rates change, the seesaw analogy doesn’t hold. And the prices of different kinds of bonds shift differently. But the seesaw captures the basic idea.
It’s important right now because interest rates have risen since the spring, and, therefore, prices have fallen. If you don’t understand the relationship between prices and rates (often called yields) you could hurt yourself “by reaching for yield, buying bonds that you think are going to pay you more interest, only to see rates go up further, so the value of your bonds will fall,” Ms. Schock said.
Many people are in danger of getting hurt this way. “We’re concerned that many people might mistakenly think that there’s safety in investing in bonds,” she said, “when there’s actually a fairly good chance of running into trouble with interest rate risk now.”
EVEN Treasury bonds are affected by interest rate risk, although the federal government backs these bonds and will pay all the principal and interest if you hold them to maturity. Such high-quality bonds are safe in many ways, especially in comparison with other assets.
Bond prices are generally less volatile than stock prices, and a major bond market decline is likely to be much less severe than a major fall in the stock market. Bonds can provide steady income and — whether held individually or in a mutual fund — can play an important role in a diversified portfolio, buffering against stock fluctuations.
But when market rates rise, you’ll run into a pricing problem if you need to sell a bond — or if you hold Treasuries in a mutual fund, where they are priced daily. All things equal, your mutual fund will fall in value as yields rise.
Interest rates on Treasuries — and a range of other bonds — have already risen sharply, and a broad consensus of market analysts says they are likely to rise further in the years ahead. . . .
If you hold your bonds until maturity — or keep them as a buffer — you may tolerate such swings.
But it’s better if you understand what’s going on. Remember the seesaw: When yields rise, prices fall."
Summing Up
What the above article fails to mention is inflation and the declining value of money over time.
That's perhaps the biggest reason of all to avoid bonds for the next few decades.
So if you want to know how likely it is that the public sector pension funds will earn their assumed rates of return over time, my answer is NO. But don't take my word for it.
Form your own opinion. A good place to start is to know how much of the total public sector's portfolio is invested in bonds.
Form your own opinion. A good place to start is to know how much of the total public sector's portfolio is invested in bonds.
In all probability, We the People won't like the answer.
A steep hill just got steeper than it seemed to be. More like trillions of dollars steeper, in fact.
That said, the truth will set us free, and getting a better reality is always a good way to begin the process of problem solution.
That said, the truth will set us free, and getting a better reality is always a good way to begin the process of problem solution.
That's my take.
Thanks. Bob.
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ReplyDeleteAt http://www.mutualfundstore.com/bonds, you can learn all about bonds, but it does sound like they might be one to avoid right now. I know my grandfather used to talk about investing in bonds years ago and how it was the best way to go, but things have changed. And we have to keep up with those changes, especially when looking toward our own futures.
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