The current recession and its accompanying bear market have many investors looking for alternatives to investing in stocks. Often these investors turn to bonds, mistakenly believing that bonds are low-risk investments. While some bonds can be safer than some stocks, they are far from being a risk-free alternative. There are many types of bonds available to investors. Today I am only going to talk about long-term U.S. government bonds, because they are generally considered to have a very low risk level.

The government issues these bonds to generate money to pay its expenditures. In essence, the person who purchases the bond is loaning money to the government. In return, the government agrees to pay interest to that investor over the life of the bond. For example, if a $10,000 bond has a maturity of 20 years and a yield of 3.5%, the government agrees to pay the investor the yield each year for 20 years. At the end of 20 years the bond matures and the government pays back the original $10,000 investment. In other words, over the course of 20 years, the investor would receive about $7,000 in interest payments and then receive full return of the original principal.

These bonds are viewed as low risk because in the past, the U.S. government has always paid its obligations. Technically, the government can never default on its debts because it has the ability to print money to pay its bills. But there are risks other than default that investors must consider when investing in long-term Treasury bonds.

Liquidity risk–These bonds require a long-term obligation.  Maturities are generally 10, 20 or 30 years. During that period, the investor only has access to the annual yield–not to the original principal. If circumstances compel an investor to sell the bond before it matures, there is a secondary market of investors willing to purchase that bond. Sometimes it trades at a premium and sometimes at a discount. Right now long-term Treasury bonds are selling at a significant discount. That means instead of receiving the original $10,000 back, an investor forced to sell today might only receive $7,000.

Inflation risk–Here is how Dr. Jeremy Siegel, currently the Russell E. Palmer Professor of Finance at the Wharton School of the University of Pennsylvania, explains inflation risk: “Although under a fiat money standard government money must be accepted as a means of payment, there is no law that says what that money is worth when it is paid. If too many dollars are issued relative to demand, inflation must result. In that case the bondholder gets shortchanged not because of a government default on its bonds but because of the loss of purchasing power of the dollars paid.”

In more simple terms, if an investor is receiving a 3.5% annual yield on a long-term bond, but inflation is running at 7% annualized rate, the investor is effectively losing money each year because the amount of goods and services he can buy with that money is declining. The same is true of the $10,000 in original principal that he cannot access during the life of the bond.

While the rate of inflation in the United States is currently quite low, some experts believe that rising inflation is inevitable in the near future because of the huge amounts of money the government is creating in an attempt to end the recession. In a recent issue of the Financial Times, Niall Ferguson wrote: “the price of key commodities has surged since February. Monetary expansion in the U.S., where M2 is growing at an annual rate of 9 percent, well above its post-1960 average, seems likely to lead to inflation if not this year, then next.” Ferguson is a professor at Harvard who specializes in economic history.

Allowing hyperinflation for a brief time is a tempting method for a government to quickly free itself from financial obligations. The government simply prints as much money as it needs to pay all its debts and then everything starts over from scratch. It is kind of like a reset button for a financial system. There are many who believe the U.S. would never allow such a situation. I personally have seen that occur on several occasions in several different countries. So to think that it could never happen here might be naive.

Opportunity risk–The long-term obligation of government bonds means the principal is not available if an investor comes across a better investment opportunity during the life of the bond. For example, over the past three months the Nasdaq has risen more than 40%. An investor with long-term bond commitments would be unable to take advantage of short or even long-term moves in the stock market. One of the reasons these bonds frequently trade at steep discounts is because it is difficult to predict what the economic circumstance might be 15 or 20 years from now. Few investors are able to commit their assets for such an extended period because of the uncertainty of things like health care concerns, employment, deaths of family members, etc.

Market risk–Many investors choose mutual funds or exchange-traded funds (ETFs) that invest in long-term Treasury bonds. This avoids the long-term commitment of actually owning government bonds. Other investors have only small amounts of available capital and cannot buy actual Treasury bonds. Unfortunately, the daily value of these funds fluctuates like any other investment traded on the open markets and an investor is subject to the same risks. Some investors think that the volatility of a bond fund will be less than that of a fund that invests in stocks. Often that is not the case.

The chart below shows the daily price movement of iShares Lehman 20+ Yr Treasury Bond Index Fund (TLT) over the past two years. The gold line is the price movement of the S&P 500 Index for comparative purposes. While TLT has significantly better performance over this period, it has experienced similar volatility. And since the beginning of 2009, investors holding this fund have seen a decline of almost 40%. So even though this fund invests in long-term Treasury bonds, it would not be accurate to describe it as a low-risk investment vehicle.

Other risks– In addition to the risks described above, there can be many other risks specific to the circumstances of an individual investor. For example, an investor who hopes to pass his estate to his heirs upon death needs to carefully consider the implications of owning long-term bonds in that situation. Because these bonds are long-term obligations, tax laws might change significantly between the time the bond is purchased and the investor’s death. Knowing the exact long-term tax ramifications might not even be possible at the time the original investment is made.

In conclusion, while bonds can be a viable investment option, their suitability for an individual investor must still be carefully considered. And no investor should make the mistake of believing that bonds are a risk-free or even a lower-risk alternative than all stocks.
F.S.