Exploding Myths About Investing in 'Safe' Bonds

July 26, 2012 — -- Investors throughout the world have been fleeing the gyrating stock market for the perceived safety of U.S. bonds, resulting in record inflows to these investments -- despite their paltry yields.

Historically, the current flight to government debt is a typical response to a volatile stock market. Investors have long sought refuge from the stormy stock market by heading for what they see as the safe harbor of U.S. government debt. These investments include Treasury bonds, Treasury bond funds, exchange-traded funds (ETFs) that hold Treasuries and savings bonds.

Is this smart money, or are these people making a mistake? Many are convinced that government debt is always a good investment because they're confident that the U.S. government, as broke as it is, won't default.

I couldn't agree more that U.S. can be trusted to pay its debts. Last summer's downgrade of U.S. credit by Standard & Poor's shouldn't bother you because it hasn't really bothered anyone else in a world where all credit tends to be relative.

But this doesn't mean that U.S. bonds are generally a good investment these days. Buying government bonds, widely viewed as ultimate sanctum of minimal risk, has its own perils. There's a good chance that many people currently seeking protection in these investments will be sorely disappointed over the next few years.

A practical way to think about any bond is to ask: Will buying it ultimately increase your actual buying power? If you're thinking about remodeling your bathroom but use the money instead to buy a bond, does this bond ultimately deliver enough profit, above inflation, to justify the wait? It doesn't matter whether your plan is to spend this money or to hold it for retirement (when you'll need to spend it). Either way, you want to increase your buying power.

Current market and economic factors indicate this is a time when many U.S. bond investments could actually decrease your buying power as father time whittles away at your principal (your initial investment). U.S. Treasury bond rates are linked with those of savings bonds and other government bonds, and are influential regarding all government debt (as well as many other types of investments), so factors affecting Treasuries are a good barometer for forecasting potential outcomes from buying various types of U.S. government debt.

Risks that currently imperil yields from Treasury bonds involve:

• Interest rates. Coupons (the annual interest rate paid by a bond issuer to the investor) on Treasury bonds are at rock-bottom. In the 1970s, 30-year Treasuries paid a whopping 14 percent annually. Now the rate is 2 per cent, so rates have nowhere to go but up. If you're holding a bond with a rate of 2 percent when rates rise to 3 percent, you'll be annually receiving 50 percent less than you could be from a newly issued Treasury bond. This gap drives down the price you could sell the bond for because buyers have the option of getting new bonds that pay 3 percent.

• Duration. The longer the duration, or term, of your bond, the longer your investment suffers from this rate gap and the less your bond is worth on the market. And you can't use this money for better opportunities. Victor Chasles, the 19th-century French writer, famously said: "The sure way to miss success is to miss the opportunity."

• Inflation.

Inflation is now historically quite low, but many economists expect it to rise soon, eating away at investment returns. You don't want to be stuck in the wrong long-term Treasury – or corporate bond, for that matter -- at 2 percent when inflation jumps to 4 percent.

How should you deal with these factors? The first option is to not deal with them at all by staying away from U.S. bonds and instead buying other investments, such as stocks. Though many analysts believe we're entering another slow decade for stock returns, a diversified portfolio of relatively low-risk stocks (like blue chips) can help you preserve capital and flight inflation.

On the other hand, if, like millions of other investors, you're so intimidated by the current stock market that you want to join the herd taking refuge in U.S. bonds, there are some ways to minimize their downsides. These include:

• Keeping durations short.

The shorter the term of your bond, the less exposure you have to rising interest rates and creeping inflation. Durations of one or two years can help you sleep at night by reducing these risks.

• Considering a U.S. bond ladder.

Laddering strategies involve buying bonds with overlapping durations so that you that you take advantage of rising coupon rates while reducing inflation risk. But keep in mind that can be complicated; ladders aren't your father's U.S. bond investment. If ladders aren't executed correctly and attended to diligently, they can be a lot of trouble for little gain.

• Investing in inflation-protected issues.

The U.S. government issues two varieties: savings bonds called I-bonds (the "I" stands for inflation-indexed) and TIPs (Treasury Inflation-Protected Securities). Both of these investments pay the rate of inflation (adjusted periodically) plus a fixed rate. That way, you are guaranteed of getting the full value of the fixed rate because inflation doesn't eat into this yield.

When it comes to avoiding default, you can't beat U.S. government bonds. But this investment is hardly secure if market and economic factors end up shrinking capital that could have found a more lucrative home. In U.S. bonds, as in any investment, there's no free lunch.

This work is the opinion of the columnist and in no way reflects the opinion of ABC News.

Ted Schwartz, a Certified Financial Planner®, is president and chief investment officer of Capstone Investment Financial Group. He advises individual investors and endowments, and serves as the advisor to CIFG UMA accounts. Because Schwartz has a background in psychology and counseling, he brings insights into personal motivation when advising clients on achieving their wealth management goals. Schwartz holds a B.A. from Duke University and an M.A. from Oregon State University. He can be reached at ted@capstoneinvest.com.