Beware of the Hidden Risks of "Safe" Bond Investments

By Ryan Snefsky

Traditionally, many investors in the general public have considered bonds to be less risky than many other types of securities. However, the current market conditions may pose some risks to that generality over the mid- to long-term.

Generally speaking, bond prices and interest rates tend to move in opposite directions. Over about the past two years, the Federal Reserve has lowered what is known as the discount rate, the interest rate it charges when its member banks borrow money, to 0.75% on primary credit. As interest rates cannot go below 0.00%, it is reasonable to say that it is not possible for interest rates to go much lower. When we consider the concept that bond prices and interest rates tend to move in opposite directions, it is also reasonable to conclude that bond prices are near the highest they will be in the foreseeable future. If we assume that to be true as well, we can also reasonably conclude that the probable direction of bond prices at some point in the future is down.

Unfortunately, there is a possibility that some in the investing public will incur significant losses in their portfolios, again, like they did when stock prices collapsed. When the stock market largely got crushed in 2008 and early 2009, many investors sold out of their stock positions, possibly for huge losses, and moved their cash into government and investment grade corporate bonds. While many of these investors think their money is now invested in something "safe," we can now see that the exact opposite may very likely be true because bond prices may very well be at their highs.

The following is a general rule of thumb when considering investments in bonds: the prices of bonds with longer maturities are more sensitive to interest rate changes than the prices of bonds with comparatively shorter maturities, when other characteristics of the bonds are equal. Therefore, if the Federal Reserve increases the discount rate by 0.25%, a bond with a longer maturity will likely experience a greater decrease in value than a similar bond with a shorter maturity.

If an investor believes that bond prices are excessively high, there are some alternatives that can reduce risk and still give the investor exposure to bonds. One way to help reduce their risk is to consider having their bond exposure be in bonds or bond funds with short maturities, such as 0-2 years from now. In this case, there is a possibility that the value of their bonds or bond funds may go down if interest rates go up in that time period. At the point where those bonds mature and the debtor is able to pay back their debt, however, the investor would get the value back and possibly even make a profit if they were purchased below par value.

Additionally, it is possible to gain exposure to bonds at lower prices than they are currently selling by buying a “closed-end” fund that concentrates in bonds. In a closed-end bond fund, investors buy an interest in a fund from another investor without actually adding to the amount of money invested in the fund. Because the purchase happens between two investors, rather than between the fund and an investor, investors can buy or sell their interests for more or less than the underlying value of their interest.

In periods of extraordinarily low interest rates, shares of closed-end bond funds are more likely to trade at a value that is less than the value of the fund those shares represent (known in the industry as trading at a discount.) The reason this tends to be true is because the fund’s investors recognize that the value of bonds will likely go down in the future, so they want to sell their shares before bond prices go down. In cases where many of the fund’s investors sell their shares in advance of the decline of bond prices, they will sometimes flood the market with the supply of the fund’s shares to such an extent that the prices of the shares go down substantially more than the future decline of the bonds held in the fund. This can create a huge opportunity for investors to purchase shares of a fund that is worth much more than the price they paid.

Buying shares of a closed-end bond fund at a discount is not by any means a homerun, however. There is always the possibility that, for whatever reason, even more of the fund’s investors sell their shares after a particular investor buys shares at a discount. Additionally, there is also the possibility that the value of the bonds in the closed-end fund go down substantially more than an investor expects. Conceptualizing the possible outcomes of a closed-end bond fund investment for a variety of possible circumstances can be difficult, particularly if you’ve never invested in them before. All of the complexities of investing in them are beyond the scope of this article. So, make sure to do your homework before considering their investment.

Lastly, there is another alternative to investment grade corporate bonds and government bonds that can provide bond exposure in a more favorable way than many bonds as interest rates rise. The following alternative, however, will likely seem somewhat counterintuitive: high-yield or "junk" bonds.

Here is the basic investment thesis. Interest rates generally begin to rise, and correspondingly erode the prices of investment grade bonds, at some point after the economy has bottomed. The Federal Reserve raises interest rates to combat inflation in periods of economic growth that often result from extended periods of low interest rates. Interest rates, however, are not the only factors that affect bond prices. Another factor is the credit rating of the company that issued the bond.

The theory is that a bond with an extremely low credit rating that has not yet defaulted on its debt will be more likely to continue to pay interest on its debt and eventually be able to repay the entire debt as the economy continues to recover. As a company becomes more likely to pay interest and eventually completely repay its debt, the company’s credit rating generally goes up. As a company's credit rating goes up, its market value generally goes up as well. Often, the price increase associated with a credit rating upgrade can more than offset the negative effects of rising interest rates. So, in a rising interest rate environment, the prices of high-yield bonds may generally increase while the prices of other types of bonds are decreasing.

This is not to say, however, that an investor should load up on high-yield bonds simply because they think interest rates are going to rise. Don't forget that high-yield bonds pay a higher than average yield to compensate investors for taking on the risks associated with investing in the debt of a company with a very low credit rating. Even though, as a generality, a company has a greater likelihood of not defaulting on its debt with the economic wind at its back, it can still default and many do.

In summary, make sure to consider that something that you might normally think of being a more "low risk" investment can actually be much riskier than you think if its price is temporarily more likely to go down in the near future than up. While some alternatives have been discussed for this unique and highly atypical investment environment, keep in mind that each of the alternatives has its own set of risks that have not been fully discussed in this article.