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Bonds Are Riskier Than You Think

There are times—many times—in which bonds can be more dangerous than stocks.

John Rekenthaler, 12/16/2016

I Guarantee It
Bonds certainly sound safer than stocks. They are required to pay their stated interest rates, whereas stocks can cut their dividends at any time—if they pay dividends in the first place. Bonds, of course, also stand higher on the credit ladder. Should the organization go under, bondholders will likely receive at least a partial payment, sometimes even better than that. Stock owners will get nothing. 

In addition, about half of U.S. bonds come courtesy of the federal government. General Motors, Kodak, Compaq, Digital Equipment, Woolworth’s, Arthur Andersen, and American Airlines went bankrupt and stiffed their stock shareholders. While those companies would have liked to have possessed printing presses with which to pay their bills, they did not. However, Uncle Sam does. And its debts are denominated in the currency that it prints. The U.S. won’t be defaulting on its obligations any time soon. 

This is all stating the obvious: People understand and appreciate the protections that are provided by high-grade bonds, particularly U.S. federal debt. Indeed, the term “government guaranteed” is so powerful that the SEC prohibits mutual funds from using it in their names. (The words once were permitted, but were banned when the SEC realized that many investors interpreted the term to mean that the fund couldn’t lose money.) 

Comparing the Records
Not so obvious is the damage that bonds can inflict on portfolios. I need not instruct this audience about interest-rate risk—but I can remind it that the concept is not intuitive. (I recall my bewilderment when learning that a security that paid its interest as promised, and that would eventually return every penny of principal to its investors, could lose money. That seemed...wrong.) Perhaps because of this lack of intuitiveness, and even more because investment returns are typically given in nominal rather than real terms, even knowledgeable investors can overestimate bonds’ safety. 

Bonds’ decade-by-decade performance has been slightly steadier than that of stocks, when expressed nominally. In the table below, I’ve shaded losing performances in red, those with annualized gains of 0% to 1.9% in yellow, and left unshaded any gain of 2% of higher. (The numbers come courtesy of Research Affiliates, supplemented by Morningstar.) The first glance confirms initial expectations. The lowest two decades came from stocks. However, the next three weakest showings came from bonds. Not outright losses, to be sure, but nonetheless not according to bonds’ reputation. One would expect them to finish in the middle, with stocks sandwiching them above and below.

 

 

is vice president of research for Morningstar.

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