Are Bonds Really "Safe" Investments?

A mutual fund company, which shall remain unnamed, has a series of funds which are named based on the year investors wish to retire. For example, the ABC-2025 Fund (pseudonym) is recommended for those who plan to retire around 2025. The company offers several of these and the only thing that differs about them is the relative percentage each fund invests in stocks or bonds. The 2015 fund is 55% stocks and 45% bonds. The 2025 fund is 75% stocks, 25% bonds. And so forth. The idea is that the closer one is to retirement the more one should be invested in bonds over stocks.

This idea, that bonds are a safer investment than stocks, is one that has been peddled for years to investors, but in fact it is very misleading.

First off, let's define the difference between stocks and bonds. Stocks are part ownership in a company. If you own a stock and the company's market value goes up, your wealth increases. If the market value goes down, your wealth decreases. If the company goes out of business, you lose everything.

Bonds are promises from a company (or government) to pay you back for money you have loaned it, plus interest. If interest rates drop, the values of bonds go up, and your wealth increases. If interest rates go up, the value of bonds drop, and your wealth decreases. If the company (or government) goes out of business, you lose everything. But if you hold a bond to maturity, as long as the company (or government) is solvent, you are guaranteed your money back plus interest. Even if the market value of the bond has dropped, if you don't sell it before maturity, you are guaranteed what the bond promised. This is one reason bonds are considered safer, and it is a legitimate reason.

Another reason bonds are considered safer is that their prices just don't move as fast or as much under normal circumstances. Stocks are the rabbit; bonds are the turtle. Sure, bonds will on average lose less money, but they will also gain less.

But here's the important point: If you plan on selling a bond before it matures, then other than its lower volatility a bond is really no safer or risk-free than a stock. The market prices of bonds can fluctuate quite a bit. This is particularly true in this age of economic crises and central bank interest rate manipulation. Below are charts of the stock market and five-year bond market for the last two years. Note that these bonds went down. They went down less than stocks went up, but the point is they lost money. This can happen at any time. So being invested in bonds does not guarantee protection from losses.

But, you say, I'll just hold my bond fund to maturity, that way I'll get all my money back plus interest. But that brings us to the most important point in this article. You cannot hold a bond FUND to maturity. Buying a bond fund is just like buying bonds that you must sell before maturity--its value is based on the market value of the fund's shares. So if you place your retirement money in a bond fund, and interest rates go up and stay up, you will lose money. The safety feature of holding a bond to maturity is not possible with a bond fund, and if you have a typical IRA, 401k or Keogh account, you are probably only invested in stock funds or bond funds. Few investors actually buy bonds directly, though it is possible to do so if you have a broker which offers them.

This is not to say that bonds are not a good investment, or that stocks are better. Both have their place. The point is that both involve definite risks.

Here's a recap:

• Stocks can go up in value.
• Stocks can go down in value.
• Stocks can become worthless.

• Bonds can go up in value (though are usually less volatile than stocks). 
• Bonds can go down in value (though are usually less volatile than stocks).
• Bonds can become worthless.
• Bonds held to maturity guarantee money back plus interest (as long as the issuer is solvent). 

• Bond FUNDS can go up in value. 
• Bond funds can go down in value.
• Bonds funds can become worthless (though highly unlikely). 
• Bonds funds DO NOT guarantee money back plus interest. 

So if you are near retirement and your investment adviser suggests moving your money into a bond fund, ask him what the outlook is for the bond market. If he says it doesn't matter, fire him.


This article is for information only and is not intended as a recommendation to buy, sell or hold any financial instruments.

The Inevitable Minsky Moment

Economist, traveler and general nice guy John Mauldin recently talked about Hyman Minsky, whose theory of economic instability I'd known of, but hadn't thought about in a while. Minky's Financial Instability Hypothesis is one of those ideas which seem to sum up things simply, elegantly and accurately, with an enticing hint of paradox. Minsky's hypothesis basically goes like this:

Stability leads to instability. The more stable an economic trend is, the more people will come to depend on it. The more they depend on it, the more they invest in it. The more they invest in it, the more imbalanced things become. The longer this goes on, the bigger the inevitable crash when it happens. The moment of collapse has been coined as "The Minsky Moment."

Here's an illustration. Imagine you are on a cruise ship with thousands of passengers on board. At one stage of the trip, passengers begin to notice the view from the port side is particularly pleasing. More and more passengers line up on the rail on the port side to enjoy the view. Due to their weight, the ship begins to lean slightly to port, enhancing the view, making it easier to stay on the port side, and less likely to move to the starboard side, since the view there is now obscured. Passengers begin to call their friends and family on board to join them. Even so, the ship, being well-constructed, holds its current pitch. Waiters and stewards now keep mostly to port, bringing food, drinks and deck chairs. The band moves to port side, and its music attracts even more people. As the trend continues, the remaining laggards, not wanting to miss out, join the party. Someone warns that the situation cannot continue. But everyone ignores him, as they are now fully invested in the belief that things will continue the way they are. Just then the ship capsizes. The trend is over. The Minsky Moment has occurred.  

In the analogy, the ship's view is the current promising economic trend. The problem is the more attractive the trend the more people tend to get over-invested in it, and the more inevitable the collapse becomes. This explains business cycles, bubbles, and even the ongoing up and down nature of stocks charts on every time frame. The excesses of the boom are the seeds of the bust. It's built into the nature of things. 

The end of the trend is inevitable. The question is not if, but when. The key then is knowing when to get on board and when to jump ship.