By Dr. Jim Dahle, WCI Founder

Bond investing, though it's dramatically safer than investing in stocks, real estate, or speculative investments, still involves risk. I'm always amazed to run into people who feel like bonds are hard to understand. The risks of bond investing are pretty straightforward, just like the expected returns.

 

Take Risk on the Equity Side

There are two main schools of thought when it comes to investing in bonds. The first is to seek out the best-returning bonds to maximize your return. The second is to use relatively safe bonds and “take your risk on the equity side.” When you invest in stocks or real estate, you know you're taking on risk. It's not a surprise to a knowledgeable student of financial history to see a 50%+ drop in the value of even a diversified equity investment or to see a leveraged investment get completely wiped out. But many investors are surprised when money is lost in fixed-income investments like bonds. They think their bond investments are safe, but some bonds are a lot safer than others.

From a tax perspective, it is more efficient to take your risk on the equity side as well. Bond returns are primarily from income taxed at ordinary income tax rates. Stock returns are generally paid at lower qualified dividend rates, and long-term capital gains tax rates (and even real estate income) are often sheltered by depreciation. I subscribe to this second school of thought. If you want more risk in the portfolio, increase the stock-to-bond ratio rather than investing in riskier bonds.

More information here:

In Defense of Bonds

 

The Risks of Bonds

There are three major risks when it comes to investing in bonds:

  1. Credit risk (the risk of default)
  2. Term risk (the risk of loss due to rising interest rates), and
  3. Inflation risk (the risk that your bonds will perform poorly on an after-inflation basis).

Let's talk about each in turn and describe what a savvy bond investor can do about them.

 

#1 Credit Risk

When investing in bonds, you should be far more concerned about the return OF your principal than the return ON your principal. Yes, it's nice to get periodic interest payments that you can reinvest or live off of, but it's more important that when the bond matures, you get all of your principal back. When credit risk shows up, you lose one and often both of these. Credit risk is the risk of default. A bond is a loan, and the borrower can make late payments or skip payments entirely. They might even not pay back some or all of your principal. The likelihood of the borrower defaulting varies by the borrower. Consider some of the people/entities you can lend to:

  1. Yahoos with terrible credit scores and high interest debt who are offering no collateral.
  2. Companies in serious financial trouble.
  3. Stable companies with a good record of earnings.
  4. Homeowners offering their homes as collateral.
  5. State and local governments with the power to tax their populace.
  6. The federal government with the power to tax and print money.

These products all exist. You may know them by the names of the securities:

  1. Peer-to-peer loans
  2. Junk bonds
  3. Corporate bonds
  4. Mortgage-backed securities
  5. Municipal bonds
  6. Treasuries

As you can imagine, the risk of default drops as you work your way down that list.

Peer-to-peer loans might have default rates of 20%, 40%, or more. In normal times, junk bonds only default about 4% of the time. But in severe economic times, such as 2008, that default rate can rise over 10%. The corporate bond default rate varies by rating. The highest-rated bonds, rated AAA, only have a 0.08% default rate over the next five years. Even bonds with a one-year default rate over 1% are still considered “investment grade.” The delinquency rate on single-family mortgages is typically in the 2%-3% range, although it was over 11% for a while after the Global Financial Crisis. The five-year default rate on municipal bonds is about 0.1%. In 2021, there were NO municipal bond defaults at all.

Most people believe the US Treasury never has and never will default on its debt. That's not exactly true. In fact, the US defaulted on its debt during the Civil War. In actuality, the US did pay on that debt, but it did so with nearly worthless “greenbacks” rather than gold. The US government refused to pay in silver or gold three other times (1933, 1968, and 1971). The US also stopped making payments on debt to France way back in 1785 and 1787, but it did eventually resume those payments and renegotiate the debt. Maybe you know all this if you've seen Hamilton.

A few decades later in the 1840s, eight US states and a territory defaulted on their debt. English investors in that debt were not happy. We missed some interest payments during the War of 1812, too (I don't think the English were all that happy about that either). Despite all this, most people consider loans to the US government to be riskless, although every time the debt ceiling comes up in Congress, people do wonder a little.

 

How to Minimize Credit Risk

How do you minimize credit risk? You simply only loan money to those most likely to pay you back. That typically means Treasury bonds, although investors in taxable accounts are often willing to use municipal bonds since their rate of default is still very low and after-tax yields are significantly better for high tax bracket investors. If you are going to invest in bonds that are not Treasuries, it is imperative to have adequate diversification against default. This is most easily done by using mutual funds—such as the excellent municipal, investment grade, and index bond funds from Vanguard.

 

#2 Term Risk

Bond values are sensitive to interest rates. If you are holding an individual bond until it matures, its value between purchase and redemption may not matter to you. However, if you're investing via mutual funds, it sure will. When interest rates go up, the value of existing bonds drops and vice versa. The sensitivity of a bond to interest rate fluctuations is mostly a function of how long it will be before you get your principal back so you can reinvest it at the new, higher interest rates. This is often measured using the time to maturity, but a better measure is the “duration” of a bond or the average duration of a bond fund. Duration is generally less than the maturity of a bond or the average maturity of a bond fund. If interest rates rise by 1%, the value of a bond or bond fund with a duration of five years will drop by 5%.

Long bonds are the most sensitive to interest rate changes. For example, the Vanguard Long Term Treasury Fund has a duration of over 16 years. Long-term Treasury rates went up by 3.2% from August 2020 to October 2022, resulting in a loss of nearly 50% of the value of those bonds. That fund recorded a loss of almost 30% in 2022 alone. This is the same problem Silicon Valley Bank had when it invested a portion of its deposits into long Treasury bonds and then subsequently failed when depositors made a run on the bank after realizing what its managers had done.

 

How to Minimize Term Risk

The main way to decrease your term risk is to only make short-term loans. Short-term and intermediate-term bonds don't have anywhere near as much term risk as long-term bonds. Cash is the shortest duration bond available. As Jack Bogle was fond of explaining, you can either have fixed interest payments or fixed principal but not both. With cash, you have fixed principal, but the interest payments fluctuate each month. With a bond, you have fixed interest payments but the principal fluctuates. As a bond gets closer and closer to maturity, it acts more and more like cash. In fact, the main investments held in money market funds (that we all think of in the same way as bank deposits) are essentially very short-term loans to corporations, cities, states, federal agencies, and the Treasury itself.

 

#3 Inflation Risk

Inflation helps debtors. If you have a low fixed interest rate student loan or mortgage, you are paying that back over time with depreciated dollars. Inflation helps you. But your debt is someone else's investment, and inflation hurts them. Sure, those investors might get all of their principal back on a nominal basis, but the money they get back won't buy nearly as much as it did when it was lent to you. Consider the student loan that I took out from the state of Alaska in 1993 to pay for my freshman year in college. It did not accumulate interest while I was in college, medical school, residency, or military service. When I paid back that $5,000 loan in 2010, I did so using only $3,290 in 1993 dollars.

Investors should always think in “real” or after-inflation terms. As the most common of the four deep risks (inflation, deflation, confiscation, and devastation), this is the bond investor's greatest enemy. In fact, it is the primary opponent for investors of all types, but nominal bonds, particularly long-term nominal bonds, are devastated by inflation. Imagine somebody who bought a $10,000 30-year Treasury in 1967. What was it worth in 1967 dollars when it matured in 1997? Just $2,068. The investor lost 80% of their principal in real terms. [Yes, I'm aware there were no 30-year Treasuries issued in 1967. It's just a hypothetical example, for crying out loud.]

 

How to Minimize Inflation Risk

There are two primary strategies for minimizing inflation risk. The first is the same strategy you use to minimize term risk: you keep maturity (and thus duration) short. That way, if unexpected inflation shows up and interest rates go way up to combat it, as they usually do, you can reinvest those proceeds quickly at the new, higher interest rates. The downside of keeping duration short, unfortunately, is that you are generally paid a lower yield, and this causes you to have lower returns that don't keep up as well with inflation. A better solution is to ensure at least some of your bonds are actually indexed to inflation so that when unexpected inflation rears its ugly head, you make a little more money on those bonds.

The main inflation-indexed bonds available to most investors are Treasury Inflation Protected Securities (TIPS) and I Savings Bonds. They work by different mechanisms, but the end result is similar—they do better than nominal bonds at beating unexpected inflation in the long run. I Bonds protect your principal even from rising real rates. Many TIPS investors were surprised to see the value of their TIPS drop in 2022 when unexpected inflation hit. But once they realized that real interest rates went up 4% that year, they were no longer surprised that their TIPS lost value.

More information here:

The 15 Questions You Need to Answer to Build Your Investment Portfolio

Municipal Bonds: How Much Is Safe?

Why Buying Individual Municipal Bonds Doesn’t Boost Your Return Over a Bond Fund

 

What Our Bond Portfolio Looks Like

Bonds make up 20% of our portfolio. We firmly believe in taking risk on the equity side (and we take on plenty, including market risk, factor risks, illiquidity risk, and even leverage risk with some investments). But we don't take much risk with our bonds. Consider our holdings (half of which are nominal and half of which are inflation-indexed):

  • TSP G Fund: No credit risk, no term risk, rapidly adjusts upward with rising interest rates in inflationary times
  • Vanguard Intermediate Term Municipal Bond Fund: Minimal credit risk, some term risk, no inflation protection
  • Schwab TIPS ETF: No credit risk, some term risk, indexed to inflation
  • Individual TIPS: No credit risk, no term risk if held to maturity (minimal anyway as most are < 5 years), indexed to inflation
  • I Bonds: No credit risk, no term risk, indexed to inflation

Even as we move away from true bonds and take on significantly more risk, we keep these three risks in mind. We consider our real estate debt as part of our real estate portfolio rather than part of our bond portfolio. These funds hold short-term, high interest rate loans to real estate developers in first lien position. While there is plenty of credit risk, the real risk of these funds is that in a severe real estate downturn, the debt funds become equity funds as they foreclose on the properties they have been lending on. By staying in first lien position, default risk, especially the risk of total loss, is decreased significantly. Term risk is very minimal given the short maturity on these loans. Their high interest rates help combat inflation, and they are typically easily adjusted upward in inflationary times.

When investing in bonds, make sure you understand your three main risks and take steps to decrease them as best you can.

What do you think? What do you do with your bond portfolio to minimize these risks?