Why Bond Investors Have Plenty to Worry About

Jan. 24, 2013— -- 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.

Another factor is that yields are already rock-bottom. A 10-year Treasury purchased for its "low risk" at the nadir of the stock market meltdown in March 2009 is now up about 20 percent, while interest rates have fallen to generational lows.

To repeat this outsize performance, yields would have to fall into negative territory. Holding onto bonds until maturity might mean a real return, after inflation, of zero or below.

Right now, high-quality, long-term corporate bonds (those with top credit ratings) are paying 3 to 4 percent annually. This seems good compared with short-term bonds paying 1 percent. But if interest rates rise just 2 or 3 percentage points — which could easily happen if inflation spikes — corporate bond portfolios could dip in value more than 25 percent. Those who hold on to these bonds until maturity would break even, assuming that the issuing company doesn't go out of business. In terms of purchasing power however, these investors could still lose out because of inflation.

Investors have been snapping up higher-risk corporate bonds and this demand has lowered risk premiums — the additional yield that investors normally demand for taking on more risk. As a result, investors are taking more risk for less potential gain, and high-yield bonds are more likely to default in bad times.

How can you protect yourself? Consider these steps:

• Go short or don't go at all. Regarding the bonds you do purchase, keep durations low — a year or two at most. This way you are exposed to less risk versus long- term bonds.

• Reduce your bond exposure. Don't wait for the music to stop take action ahead of the crowd. Baron Rothschild once said, "I made my fortune by selling too early." The exact timing of a bubble bursting is hard to pinpoint but it is always better to be early than late. Besides, bonds unlike stocks, are truncated in their gains in terms of price appreciation.

• When setting your investment goals the primary goal should be to maintain your purchasing power. To achieve success you may have to set your investment goals higher than originally planned as inflation accelerates. Many investors make the mistake of using a long-term average assumption which may not be suitable in today's environment.

If you decide how much of your assets to put into bonds based on historical returns of the bond market over the past 30 years, you could end up being sorely disappointed. This may be like using an assumed 8-9 percent return for equities in 2000.

The last bear market in bonds lasted 40-plus years. In the past, these types of actions have led to a long-term increase in inflation. Keep a close eye on your wallet.

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

Craig J. Coletta has 20 years of experience in the financial industry. He is president of C.J. Coletta & Co., a Registered Investment Advisor firm, and president of Coletta Investment Research Inc. Coletta is a Chartered Financial Analyst charterholder, a Chartered Market Technician and a Certified Hedge Fund Professional. He holds a B.S. in accounting and business administration from Rider University, and is a member of the American Institute of Certified Public Accountants.