THE SAFE BOND MYTH DIES HARD
by Mark Scheinbaum
American Reporter Correspondent
Lake Worth, Fla.
LAKE WORTH, Fla., July 30, 2003 -- Just before the Fourth of July weekend, most Americans with good credit could secure a 30-year fixed mortgage for about 5.31 percent. Less than a month later, in most cities, the same mortgage might cost 6.25 percent.
I speak in mortgage terms because unless you have always rented your home or apartment, it's the closest thing you have to expertise in the wild and sometime mysterious world of bonds. Each day radio listeners call or email me to offer the pronouncement that "bonds are safer than stocks." It depends on your risk aversion, years until retirement and/or death, and view of America. But except for very, very short-term bond maturities, the blanket belief in bond stability and safety is mostly a myth. Bonds depend on credit ratings, issuer, maturity, and relationship to overall interest rates. The sad rule of thumb which many mutual fund owners will learn on their next statement, is that the longer term bond funds which have made money, or preserved principal over the past three years - throwing off 3, 4, or even 7 percent (in corporate bond) interest, have taken a big hit. Wall Street's "Rule of Thumb" on long-term government, municipal, and corporate bond portfolios of investment grade is that for every rise of one percent, you lose 12-13% in principal value. In simple language: place $100,000 in a nice bond fund yielding 5 per cent when mortgages are 6 percent; at some future date when you see those mortgages at 7 percent, that fund will be worth about $88,000 if you cashed it in. You get your $5,000 in income, but if you had to sell at $88,000 your "total return" of $93,000 means you lost 7 percent for the year. Is an 8 percent mortgage rate possible? If that happens, your fund might be worth $76,000. Safer than the long-term investment in conservative, investment-grade stocks that pay a dividend? I think not. "Junk" (low-rated) bonds could improve in creditworthiness in an improving economy, and outpace the dollar loss at times, but in many cases the junk status is really not suitable for retired or cautious investors. Of course, the converse is true. If today's 6 percent mortgage falls back to 5 percent, the $100,000 would (and has) become $112,000, plus interest. The real-world problem is that a typical investor in the 33 percent tax bracket rarely takes his or her "winnings" of $12,000 off the table. After taxes they might have only $8,000, and the lower interest rates which made your old bonds more valuable have given you fewer places to reinvest. I asked Gregory Panagos, a colleague who is director of fixed income for Kaplan & Company, to explain the myth. He noted:
"Their logic stems from getting their 'chestnuts' ripped off in the stock market over the past few years ... John Q Public is quite satisfied with a nominal small return, while sleeping soundly, feeling that his principal dollars are still going to be there when he wakes up. Flight to quality? Maybe not. Flight to safety? Definitely. Until we see a trend of upward motion in the Dow, bonds will be a safe haven, no matter what the prevailing percentage rates are." Apparently, he's correct, because I have seen very few clients bailing out of bond funds from the major fund companies. The sophisticated institutional investors, trust managers, insurance companies, and some high-net-worth individuals utilize mathematically complex derivatives of mortgage bonds back by government agencies, or quasi-governmental agencies. These CMO's (collateralized mortgage obligations) of Freddie Mac, Fannie Mae, and Ginnie Mae sometimes have variable, interest-only, or "inverse" features which are constructed to actually gain value in a rising market.
Unfortunately, most retail brokerage firms will not offer them to smaller individual clients, and save the strategies for themselves and their biggest clients. So the typical investor is left with a corporate or government bond fund which gets the write-ups in financial magazines by hyping "yield." As I mentioned above, yield means little if your interest is eroding. I've lost many of you by now. How do I know? Well, in lecturing many times on the subject, some folks have decided it's just too complicated. A final attention-getter is usually to use old, dull, Certificates of Deposit, or CDs. Look at bonds this way: If in 1996 you could buy a 10-year CD for $10,000 paying 8 percent interest every year, and now in 2003 it still has three years to go, that would be good. Right? Since nothing short-term, insured, and sold at your bank is paying 8 percent for the next three years, your neighbors who are buying 3-year CD's paying 3 percent would kill for your CD. Well, "kill" might be too strong, but they would pay you more than $10,000 to get that fat 8 percent yield. This is called a bond "premium." A retired person who had some cash now, but wanted the peace of mind of receiving 8 percent for the next three years, might pay you $10,200 or $10,500 to take that CD (bond) off your hands. Today's market is the opposite. You might have three, five, or 10-year CD's paying 4 percent. In a few months or years every bank might be offering seven or eight percent. No one wants your bonds at "par" (100 cents on the dollar). To "take it off your hands" you have to sell at a "discount" to that $10,000. Your friendly bank never gives you the upside potential for "early withdrawal," but they sure as hell cover themselves on the downside by charging everyone a penalty for cashing in early, just in case interest rates rise. There are some ill, old, frightened, or extremely wealthy people for whom an overweight position in long-term bonds is prudent or even a needed diversification. But for most younger and middle-aged investors who think that the word "bond" automatically means safety, the mere return of principal in some future year, unadjusted for any return of inflation, is hardly a safe alternative.
Mark Scheinbaum is chief investment strategist for Kaplan & Co. Securities, members Boston Stock Exchange, NASD, SIPC, based in Boca Raton, Fl and reachable at www.kaplansecurities.com