by Steve Cassaday, CFP®, CFS

Although considered to be “safe,” or at least safer than stocks and hard assets, bonds have risks that, if fully understood, would strike fear in the hearts of most lay investors.

With the unprecedented volatility in the stock markets and blood-curdling daily headlines about the impending collapse of the universe, investors have lunged headlong into bonds. Since 2009, investors have put $633 billion into bond funds while withdrawing $200 billion from stock funds, according to J.P. Morgan.

What investors think is a safe haven could turn out to be a tender trap with terrible returns. Coupled with potential lost opportunities in riskier assets, that may be a recipe for real setbacks for people who may need their investment portfolios for supplemental cash flow during retirement.

Bonds are essentially an IOU issued by a borrower with a promise to pay interest and at some point in the future a fixed maturity value. Bonds can be classified by the type of borrower: government (U.S. or foreign), municipal and corporate, among others. Their attraction is the certainty they offer in potential cash flow and return of principal.

This is an important point: Bonds can be more certain but are not necessarily safe.

Bond risks fall into three general categories. Credit risk is the possibility that the borrower fails to repay interest and principal (think Greece or subprime mortgage bonds). Purchasing power or inflation risk means that the fixed interest paid by a bond may not be enough to beat inflation. Interest rate risk is the danger that higher interest rates in the future may make the interest on bonds purchased today uncompetitive, driving bond prices lower. This effect is usually pronounced for longer-term securities.

The last two risks are increasing, while the first is decreasing.

Due to sustained low interest rates, corporate and personal balance sheets are improving in quality through restructuring and refinancing of debt. This implies that there is less credit risk and potentially less risk of nonpayment or default. Most borrowers, including consumers, are deleveraging, with the notable exception of certain governments. As the economy improves, creditworthiness improves and thus default risk drops.

Although the current tableau is fixed on default, we think the real risk lies elsewhere.

With only a few interruptions, we have enjoyed a 30-year bull market in bonds. Since its peak in 1982 at 15.75 percent, the benchmark 10-year U.S. Treasury yield has dropped steadily to its current level, near historic lows. In general, as interest rates drop, bond prices increase, hence the favorable long-term returns on bonds up to this point.

The problem is that the converse is also true. With bond yields so low, a relatively small increase in interest rates could have a devastating impact on bond prices.

At current levels, a 1 percent increase in 10-year yields would result in a decrease in market price of 8.8 percent. On 30-year bonds, the price decline would be 18.7 percent. Few bond buyers would consider this a good return. Although rates could go lower, the risk-reward scenario on bonds vis-a-vis interest rates is not attractive at this time.

The other risk is that inflation becomes a problem. There is more money in circulation at this time than ever before because the Federal Reserve Board has liquefied the system (printed money) to prevent systemic collapse. Although there is a lot of money in circulation, it is not being spent; it has no “velocity.” If the economy heats up and the “velocity” of these dollars increases, we could have very high inflation, which would be particularly bad for bonds and their low single-digit fixed rates of return.

Although the prevailing wisdom is that the Fed will keep long and short rates low, that will change quickly if the economy heats up.

The perfect storm for bonds is an economic recovery that brings about higher inflation and interest rates. The combination of these two could be devastating for bond investors but could be good for risk assets like stocks, real estate and commodities (raw materials).

The potential exists for an extreme polarity of returns between bonds and risk assets. Speak with your financial adviser about these potential outcomes and determine what portfolio configuration makes sense for your situation.

As seen in the 10/28/2011 issue of Washington Business Journal