Investors talk about bonds as a financial holding and most own some. But I find few people really understand them. Why are they are considered safer than stocks? Why at times might they not be as safe as thought?Within the investment realm, one can only choose among four basic types:
- own money (currency)
- own tangible stuff (land, gold, silver, paintings, etc.)
- own a business or part of it (stock)
- lend it to borrowers for a time period (bonds)
Everything else is an offshoot of these I would suggest.
I am using bonds as a much-too-general term for this lending. The concept could include Certificate of Deposits, a loan to your cousin due with 5 percent interest on January 1, 2020, or one to the US Government due in November, 2047, 30 years hence.
In each case, the investor does not primarily care about the financial welfare of the borrower so long as he or it will be able to pay back the principal with the agreed upon interest rate. The interest rate is the cost of the money.
Since the 2008 financial crisis, the Federal Reserve has felt the need to make the cost of money almost nothing. This is the primary reason why the recovery from it has been the weakest or slowest in our history. In some other countries, lenders are paying the borrowers to take their money and use it! This is called negative interest. In other words, the borrower is doing the lender a favor to take his money and the lender takes a loss on the investment. My advice? Don’t ever make that investment.
One of the most important determinants of interest rates (cost of money) is the level of inflation, both currently and expected. If you are willing to lend money to your Uncle Sam at about 2.9 percent* per year until November 2047, and you are otherwise rational, you are optimistically expecting the inflation rate for almost 30 years to be extremely low.
If you receive annual interest of $2,900 a year on $100,000 invested, the total interest equals $87,000 plus you receive $100 grand back. If inflation and taxes cost you more than 2.9 percent per year over the 30 years, you also will have lost money on the transaction. That is, the money that you are repaid even including the interest is less than the value it takes to buy your cost of living. That is also not a good idea.
Why do people do this then? Since 2008, worried investors have most focused on the supposed safety of their principal. If the government runs out of money, it will just print more and send you some, right? When anxiety reaches this level, people would rather lose some money slowly than to risk losing more. Even in a bond bear market, losses of value are usually less than in stock market corrections or crashes.
In my next installment, I will explain what will be happening to the value of bonds and bond funds as current and future interest rates rise.
(Past performance is no guarantee of future results. Advice is intended to be general in nature.)
*2.86 percent yield quoted, January 23, 2018, TD Ameritrade Institutional.