Why Bond Investors Have Plenty to Worry About

PHOTO: Investors view bonds in general as being less risky than stocks because they are less volatile

Bonds, which have been in a bull market for 30-plus years, may have lulled investors into a state of complacency as prices have risen and volatility has been low.

Incorrectly viewed by many investors as a risk-free haven, bonds go through long bear markets in which wealth is destroyed. The last bear market in bonds started in 1940 and lasted until 1981. During that period, bond investors lost money in real terms due to rising inflation and interest rates.

Investing is more complicated than getting your money back with interest. The greatest threat to investing successfully for retirement is losing your purchasing power from inflation. Inflation acts like a master pickpocket. Instead of stealing your wallet, it effectively switches $100 bills for tens over time. You don't realize you've been robbed until later, when you go to buy something, reach into your wallet and are shocked to find you don't have enough money.

Investors view bonds in general as being less risky than stocks because they are less volatile, and government bonds as being highly secure because there's a high probability that they will get their money back.

Contrary to the popular view that government bonds are always an ultra-safe investment, the current bond bubble includes Treasuries, signaling risk aplenty, according to professionals including legendary value investor Wilbur Ross and successful hedge fund manager Leon Cooperman. Instead of being safe, these investments are in a larger bond bubble that may be about to burst, with dire consequences for investors.

If you own a long-term Treasury bond paying a rate of 2-3 percent annually and inflation jumps to 4-5 percent (which is increasingly likely after a long period of historically low inflation), you will ultimately get your money back — but you'll have less buying power. In real economic terms, you will lose money over time. In the 1970s, inflation skyrocketed, devastating bond investors' purchasing power.

You doubtless remember the recent housing bubble, which left many homeowners underwater on their mortgages and unable to sell. If there is a rush for the exits in the bond world, investors overloaded in bonds may be similarly stuck.

When the bond band music stops, there won't be enough chairs for investors to sit in. History has shown us that when bubbles burst, crowd psychology and sentiment can change on a dime. When people realize this folly, they begin to sell, and the price plummets.

Like all bubbles, the bond bubble has been fueled by high investment. Since 2009, about $900 billion has poured into bond mutual funds as investor dollars have rotated out of equity funds amid stock market declines, including the 2008 meltdown.

For skittish investors, the return of their capital — their initial investment — is more important than return on their capital. Bond investors have long been blessed with low inflation. But ultimately, the question isn't whether inflation once again rears its ugly head, but when.

If your portfolio is heavy in bonds and you are approaching retirement, a bursting bond bubble with rising inflation could mean that you'll have a far smaller nest egg than you had planned. Depending on your portfolio structure and your total resources, this could result in the worst of all retirement investment outcomes: outliving your money.

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