As a type of fixed-income security, bonds might give you the impression of safety and stability—they usually just pay you the agreed amount of coupon payments throughout the years, and you will receive the principal payment sometime down the road. Nevertheless, the cash flows of bonds seem to be certain, which therefore could give you peace of mind. But is it what it seems?
First of all, the term “fixed income” is misleading, especially for those who are not familiar with finance and investment—it passes on a false sense that you can possess a guaranteed income once you purchase a bond. The reality, however, is that there are numerous risks involved in bond investment.
The most obvious risk is the default risk, or it is also known as the credit risk—the risk that you will stop receiving the agreed payments from the bond issuer—it might have gone bankrupt. You might say, “Well… I will just buy US government bonds, which are considered risk-free assets.” Fair enough…
Imagine that you purchased a risk-free T-bill that yields at 4% and matures in 1 year. Just as you were lying on your sofa and trying to decide whether you should spend the extra 4% on a trip to Barcelona or a new dishwasher when the bond matures, you turned on the television and saw that the inflation is now at 8%—all of a sudden you might have to use your 4% gain to pay the utility bills. This is called the inflation risk.
Since the beginning of the 1980s, we have been seeing a downward trend of interest rates, which is reflected in the 10-year Treasury yield (the blue line), and we are now used to the near-zero level of interest rates. One consequence of low-interest rates is that the treasury yield can now hardly cover inflation. The orange area on the chart shows the bond yield in excess of the inflation rate of the US measured by the CPI (consumer price index, a most common measure of inflation), or in other terms, the real return of US Treasuries.
Data Source: Bloomberg, FRED
Inflation risk can be reduced by purchasing what’s called the TIPS—Treasury Inflation-Protected Securities, whose principal value will be adjusted based on the CPI, but that also means you will gain less when inflation rate starts decreasing.
And there is the interest rate risk. Recall that the value (price) of any asset equals the sum of its discounted future cash flow. Assuming that a bond will not default, which means the cash flows are given, the only thing that will affect the bond price then becomes the discount rate, or yield-to-maturity (YTM) in terms of the bond. The YTM is determined by the market, and the market rates ultimately depend on the target interest rates set by central banks. Bond prices will fall as YTM increases.
So here comes another implication of low-level interest rates—they only have the space to go up, which means depreciation of bond value. Starting in March 2022, the Federal Reserve increased the target rate 11 times and brought the rate from 0% to 5.25%, though the market believes that the interest rate peaked in October of last year. How have the US Treasuries performed during that period? The price of Treasury bonds with maturities of 10 years or more had dropped by 46%—nearly as bad as the equity performance during the burst of the dot-com bubble. Do you still think a bond is a safe investment?
For individual investors, purchasing bonds directly to increase the allocation in fixed income is often unrealistic—they are too expensive. Therefore, investing in fixed-income ETFs would be a sensible alternative. If we use the Vanguard Total Bond Market ETF (BND), which is an aggregate of public investment-grade fixed-income securities in the US, as a proxy of bond investment, we will end up with an average annual return of -3.33% in the past 3 years as of January 30. If one were to invest in the fund as early as January 2008, he/she would receive an average annual return of -0.35%; if all dividends were reinvested, there would be a cumulative return of 53% (avg. annual of 2.68%), while he/she could make a return of 358% if invested in the SPDR S&P 500 ETF (SPY), and note that January 2008 was before the crash of stock market during the financial crisis.
In conclusion, investors should not be tricked by the term “fixed income” as there are many risks involved when investing in bonds. With the interest rates at near-zero levels, bonds provide little real return for investors, and the value of the bond portfolio will suffer great losses when interest rates rise. Given the level of risk that comes with bonds, investors should put more focus on equities as they provide much more attractive returns for bearing the risk and are better hedges for inflation.
Disclaimer: The statements provided are based solely on the opinion of the author and are being provided for general informational purposes only. Please be sure to consult with a professional financial advisor before making any investment decision.