Monday, November 19, 2012

Assessing the Risks in Today's Bond Market

The re-election of Barack Obama probably means that Ben Bernanke remains Fed chair until at least the end of January 2014, when Bernanke's term officially ends.  At that time, it is likely that Bernanke heads back to Princeton.

For investors, this means that yields will remain at record low levels for at least the next couple of years.  Bernanke's Fed is on record that they would like to keep mortgage rates, as well as other lending rates, as low as possible in order to spur economic growth and create more jobs.

However, at some point, interest rates will gradually begin to rise. While investors in bonds will at least have the security of knowing getting their principal back when their holdings mature, the trillions that investors have moved into bond mutual funds over the past five years have no such certainly.

The blind rush to bond funds despite today's record low level of interest rates is in some ways reminiscent  of the dot-com era in the late 1990's.  It was widely known at the time that stock investors were being "irrationally exuberant" when it came to their expectations about future stock market returns, yet it was not until the music finally ended in 2000 that the pain truly set in among investors.

However, what's even more disturbing about today's rush to bonds is the paltry return that investors are receiving for their hard-earned savings.  If you invested in stocks in the late 1990's,  and avoided the most speculative sectors, you at least earned some sort of return over the next decade.

Today's Financial Times has a long piece titled "A False Sense of Security". I describes in detail the risks that bond investors face in today's low yield environment.  I suspect that we will look back at such articles a few years from now, and wonder "Why didn't they listen?"

Here's an excerpt:

What is missing, argues Seth Masters, chief investment officer for asset allocation at Alliance Bernstein, is a long-term perspective.  He says short-term thinking and fear has inflated "safety bubble" pushing up the price of assets across the fixed-income markets while boosting supposedly low-risk dividend stocks, as well....

Mr. Masters says starkly that a bond portfolio will not provide enough income to cover a retirement that just might last 30 years. "The risk of ruin at that age, it sounds dismal to me.  Yet the risk of ruin after 30 years approaches 100 per cent if you are a typical American and if you have a portfolio in bonds right now."