The Great Bond Crash of 2011 (1/26/2011)

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The Great Bond Crash of 2011

Remember the tech bubble of the late 1990’s and how that bubble burst in 2000? I believe that the bond market is currently in a bubble. I also believe that the bubble could burst in 2011 in one of the worst bond market crashes in memory.

But before I get to that, I am going to answer your burning questions first, which are: Would a bond crash mean the The End Of The World As We Know It? Would it mean the fall and destruction of the United States? Would humanity melting down into a Mel Gibson Road Warrior existence?

If you watch other videos on the subject, you would think western civilization is on the edge of destruction. But the situation is not quite that dire. The worst case scenarios are probably that:
1) Bond investors could experience significant losses of value on their bond holdings.
2) Prepared investors could protect principal and get higher interest rates on their investments.

So let’s look at what a “bond crash” means, how that would affect you, and what you should be doing to protect yourself.

To understand the bond bubble, we must first understand what bonds are and how they work. So what is a bond? A bond is simply an IOU. It’s a loan. The loan can be to a government such as the federal government. These bonds are called Treasury bonds. If the loans are to a local governmental entity such as as your state, city, or local school district, they are called municipal bonds. If the loan is to a business, they are called corporate bonds.

When you buy a bond, you earn a specific interest rate for a specific period of time. For example, if you bought a 4%, 30 year treasury bond for $100,000, you would receive $4,000 per year for thirty years. At the end of that time, the bond would mature, and you would get the principal value of $100,000. It’s really that simple.

The part that confuses most people is the “market value” of bonds. Like stocks, bonds are traded in a market. Not surprisingly, we generally call this the “bond market.” Hundreds of billions of dollars of bonds are traded every day in the bond market.

So, if you’re going to understand what “bond crash” is, you have to look at the relationship between the market price of bonds and interest rates in the market. The best way to see this is with a quick example. Let’s go back to the example we had before. Suppose you own a 30 year Treasury bond with a 4% interest rate. You decide that you need to sell the bond. However, interest rates in the market are no longer 4% but 6%. Do you think an investor would pay you $100,000 for your 4% bond when he can get buy a brand new Treasury bond at 6%. Of course not. Is you bond worthless? No. Your bond is worth something though, just not $100,000.

If we do some math, we can figure out what an investor could pay for your bond and still get a 6% return. In this case, an investor could pay you $72,470 for your bond and get a 6% yield to maturity. If we say it another way, the market value of your bond is only $72,470. When interest rates rose 2 percentage points, the value of your bond declined over 27%. Notice that the only thing about your bond that changed was the market price. You are still going to get your $4000 per year interest payments and at the end, you will get $100,000.

If you kept this bond in your sock drawer, you probably would not know that your bond lost over one-fourth of its value. But what if you keep your bond in an investment account? When you received your statement, you would see that your account went down in value. You would then call your financial professional who would explain that the value went down but you would still be getting your interest and you would still get the principal value when it matures.

I find that the unhappiest people in a bond crash are those that own bond mutual funds. When interest rates in the market rise sharply, people who own bond mutual funds can experience huge losses. When you consider that people usually buy bond funds for good dividends and relative stability of principal, big losses in a bond fund can be extremely disconcerting.

Now, another thing that can affect bond prices is credit quality. Credit quality is simply the ability of borrowers to repay their debts. If investors think that there is an increased risk of not getting paid, the bond value will decrease.

I want you to think back for just a second. Do you remember 1994? Let me give you hint. Now do you remember 1994? Remember the famous low-speed chase between OJ Simpson and the Los Angeles police? That event took place on June 17, 1994.

Later that year, while the OJ media frenzy was in full swing, another significant event occurred in the same location. On December 6th, 1994, Orange County declared bankruptcy. You probably don’t remember it, but bond values across the country dropped like a rock.

To make matter worse, this shock occurred at the same time that the Federal Reserve was raising interest rates. This one-two punch created the worst bond crash since 1926. Many bond investors had losses in their bond portfolios of 20% or more.

So why don’t people remember the bond crash of 1994? Well, by the time the OJ Simpson trial wrapped up in the fall of 1995, the bond market had fully recovered. The Federal Reserve lowered interest rates and Orange County was emerging from bankruptcy. People who owned bond funds had recovered most if not all of their losses.

So how is 2011 similar to and different than 1994?

First, just like in 1994, there is a high probability that the Federal Reserve will raise interest rates. Over the last thirty years, interest rates have been on a long down trend until they now hover just above zero. The fact is that rates cannot go below zero. With rates so low, the odds are that interest rates will be higher in the future, not lower.

The difference is that in 1994, rates were at much higher levels. After the crash, rates fell again and losses were recovered. If rates rise in 2011, there is the possibility that interest rates may never return to these historically low levels. In other words, we may not see a bond market recovery as occurred in 1995.

Another factor is that municipalities all across the country are in dire financial condition. That means that the odds of an “Orange County” type municipal bankruptcy are better than average. For example, here is a map showing the Forbes credit quality of each state. The darker the state, the worse the debt quality. While the problems in California and Illinois are well publicized, you can see that debt problems affect a wide swath of the states. Does this mean that there will be a spectacular bankruptcy? No. I’m just saying that the possibility of one is higher than in the past.

These problems are not going unnoticed in the bond markets. Remember, when bond prices go down, interest rates go up. Here is an article from last week’s Wall Street Journal. As you can see, rates on 30 years Triple-A municipal bonds have shot up over the last three months. This indicates that investors are beginning to move away from municipal bonds.

In fact, over the last couple of months, all interest rates have been going up quite rapidly. Here is a graph showing the interest rate level during 2010 on 10 year Treasury bonds. As you can see, interest rates have risen three-quarters of a percentage point over the last three months. It may not sound like much, but in the bond world, this is huge. And remember, this rise in interest rates directly corresponds to a decline in bond prices.

So, what should you do?

First, I would suggest that you avoid bond funds that can lose a lot of value if interest rates rise. You can do this by looking at a fund’s “duration.” You can get the duration on your bond fund by calling your bond fund company or going on the Internet. Duration is quoted in “years.” I won’t go into why its quoted as “years,” but forget the years part. The duration will tell you how much your principal value will decline for every percentage point interest rates rise in the market. For example, if the duration on your bond fund is 7, and interest rates in the market rise by 2 percentage points, then the value of your bond fund will fall by 14%. If rates in the market rise by 3 percentage points, then the value of your bond fund will fall by 21%. Use duration to choose funds that will lose less if interest rates rise.

Another strategy is to avoid using bond funds altogether. Instead, you may want to use investments that have a maturity date. These include CD’s, savings accounts, fixed interest annuities, etc. While these types of investments don’t pay much interest right now, they do protect your principal.

Another thing I would recommend is to avoid investing in investments that act like bonds and are sensitive to interest rate changes. These include preferred stocks and some utility stocks.

Finally, I suggest that you avoid what I call “something for nothing” bond funds. These funds use option strategies to increase yields. The funds frequently blow up in markets where rates rise or fall quickly. The names on the funds frequently hint at the strategies. Names you might see might be “Yield Plus” or “Option Income.” The funds promise higher returns with less risk. Remember, in the financial world, there is no “free lunch.” If you want higher potential returns, you have to take on more risk or pay higher costs.

While a bond crash in the near future would not mean the end of the world as we know it, unwary investors could suffer unexpected losses. By keeping our eyes open and staying alert of the situation, we can take steps to protect ourselves in these times of change.

I’m Michael Dallas