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Bond Risks and Duration

     Recently, some very prominent individuals have been warning about risks in long-term bonds and/or suggesting they have unattractive risk/return tradeoffs. In particular, some are suggesting US government bonds (which are often described as "risk-free") are actually very risky and may offer "return-free risk" given their yields relative to expected inflation. I've been collecting quotes on the topic from a diverse group of experienced investors that all appear to consider long term bonds to be particularly risky investments at this time. Three of the eight individuals quoted below also warned in advance of the Global Financial Crisis.

The bond outlook is extraordinarily bad”
Jeremy Siegel in Why stocks will beat bonds over the next 20 years (1/9/2012)
"We are literally running out of superlatives to describe how much we hate bonds. Yields are pitiful, dangers of even a slight recovery that could wreak havoc for long-duration portfolios loom, and monetary policies globally certainly have added to the specter of rising yields."
Jeremy Grantham in GMO Quarterly Update (1/31/2012)
"Though longer-term Treasury bonds were among the best performing asset categories last year, consider the risk taken. Who would be willing to buy them, at these absurdly low yields, unless they were able to sell quickly? I believe no one. It’s speculation since there is little, if any, underlying real value. Protect your capital and stay within a three-year maturity."
Bob Rodriquez in Caution: Danger Ahead (2/15/2012)
"I don’t think people understand how risky a US government bond is at 2% return."
Leon Cooperman has `No Interest' in Treasuries (2/22/2012)
"Current rates, however, do not come close to offsetting the purchasing-power risk that investors assume. Right now bonds should come with a warning label."
Warren Buffett in Berkshire Hathaway Shareholders Letter (2/25/2012)
"We suspect this will prove a lousy year for high-quality bonds"
James Paulsen in Economic and Market Perspective (Feb 2012)
"Essentially, what we have right now in the Treasury market is a Ponzi scheme. If the market had its way, Treasury rates would be at least 100 basis points higher than they are today. But because there is a buyer out there who is willing to keep purchasing these securities, even though it doesn’t make any economic sense as a prudent investment, the market has reached levels that wouldn’t be sustainable if free market forces were allowed to prevail. The bottom line is Treasuries at current levels are exceptionally overvalued."
Scott Minerd in Winning the War in Europe (March 7, 2012)
"Interest rates are now artificially low, and high-quality bond portfolios are unlikely to produce positive real returns."
Burton Malkiel in The Bogle Impact: A Roundtable (March/April 2012)

     Bonds have many "risks" with a major one being the risk of loss in value due to increasing interest rates. The Federal Reserve has been actively influencing rates, but arguably when the Fed stops pushing down rates and/or their influence on the market weakens, US rates could rise. When interest rates rise, bonds lose value. All other factors being equal, the longer the term and the lower the yield, the larger the price movements in bonds due to interest rate movements. JPM research summarizes the end of QE spells either bond carnage much worse than 1994, or inflation (3/6/12).

     Even though some have suggested everybody hates treasuries, there are of course plenty of people that don't agree that investors should consider shying away from long-term bonds. While US rates have been low (relative to recent history), rates are even lower in Japan, which has even greater debts than the US. Bill Gross has defended Treasuries (2/23/2012) and Gary Shilling ranks Treasury bonds as favorable) with a 2.5% yield target, while this July 2010 Vanguard paper Risk of loss: Should investors shift from bonds because of the prospect of rising rates? suggests the risks are not as great as some would have you believe. Banks have been buying treasuries at seven times the pace in 2011 (3/12/2012) according to Bloomberg and this article discusses bond yields, activity and the big investment firms positioning on bonds (3/11/2012).

     So what should investors do if they want to reduce their bond risk? Some investors that believe the risks currently outweigh the rewards in long bonds may decide to shift out of bonds and into other asset classes, but if the specific risk you want to reduce is interest rate risk, one option is to avoid long-term bonds as opposed to all bonds. A conservative option is to seek shorter durations (personally, I have been gradually shortening durations by moving from long-term funds to shorter-term funds). A rule of thumb with duration (which you can find for funds at Morningstar) is for every 1% increase in interest rates a bond fund will drop in value by 1% for each year of average duration. For example, if the average duration for the bond fund is 7 years and interest rates go up 2%, the fund will tend to lose roughly 14% in value, while a fund with a 2 year duration will drop roughly 4%.

     I tend to avoid market timing and the graphic in The Rally That Wouldn't Die! (1/14/2012) illustrates the danger of trying to time the end of a long-term trend. But for those that believe in long term reversion to the mean or those that are contrarian, recent returns could signal that the bulk of the bond rally has passed (and the trend could be on the verge of reversing). Per Morningstar, Long-term government bond funds returned 32.9% in 2011. Only a small % of that was from interest. Most of that was from price increases due mainly to interest rate decreases (although there are other factors, like default risk relative to alternatives). The point is that if you can make over 30% in one year in low yielding "safe" bonds, you can obviously lose nearly as much if interest rates rise by the same magnitude as they dropped in 2011. For the last 5 years long-term government bonds returned 11.2% annually, outpacing other categories including equity precious metals.

     Investors concerned about inflation risks will tend to be more attracted to TIPS as opposed to traditional treasury bonds. Bonds also have risks related to their credit rating and Marc Faber believes U.S. Bonds Should Carry ‘Junk’ Rating (1/20/2012). US Government bonds are considered risk-free in regards to default risk, and in theory other assets are priced based on their default risk relative to the US bonds. Buffett cites Shelby Cullom Davis and suggests perhaps this quote applies today - “Bonds promoted as offering risk-free returns are now priced to deliver return-free risk.”

     There was plenty of talk about a bond bubble in recent years, but I haven't heard the term used as often recently and perhaps that's because many that took positions attempting to profit from rising rates in recent years were proven wrong thus far (an often mentioned example). But perhaps they were just early, just as many that predicted the global financial crisis were early in predicting the housing bubble bursting. In fact, the first person quoted above is Jeremy Siegel and he coauthored an article titled The Great American Bond Bubble in the WSJ on August 8, 2010. Personally, my concern is what will happen with fund flows if/when investors (individuals and institutions which still expect over 7% returns) start seeing losses in bonds and if discussions about a bond "bubble popping" increase. While bond holders always have the option of holding their bonds to maturity (in which case what happens to rates doesn't matter if they spend the money as it comes in), many could be tempted to sell at the same time others are also heading for the exits. Some prior related discussions include the following.

     More balanced discussions of whether we had a bond bubble (over a year ago) include the following.

Gary Karz, CFA Follow GKarz on Twitter
Host of InvestorHome
Founder, Proficient Investment Management, LLC

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