Jilted Lovers

February 10, 2012by Hoy Grimm0

With that headline, we could launch into any number of topics:  politics (left and right), Hollywood or even Facebook, which is the saddest place on earth on Feb. 14. Investing in the stock market for the past decade has been a fruitless affair for investors as it wrought many broken hearts and dashed our dreams of financial bliss.

Bond investors on the other hand faithfully feel bound to a reliable partner that has carried us through the “better and worse.” I have concern for bond investors, because the most durable relationships are forged through tribulation; they have seen almost no trouble in the past 25 years.

Bond investors can suffer loss through a number of risks:  credit risk, inflation risk, event risk and liquidity risk—to name a few. By far, the biggest risk to principal loss is inflation risk, because all bonds are subject to it. By equating inflation risk with the direction of interest rates, we graphically can depict how easy the road has been for bond investors. The chart below tracks the yield on 10-year U.S. Treasury bonds since 1982:

For the past 30 years, yields have been in a steady decline, putting a stiff wind in the back of bond investors. With these yields currently hovering around 2 percent, they don’t have much farther they can drop.
Compared to stock investors, bond investors have had three decades of mostly smooth sailing. They are overdue for some turbulence, and I am fearful they are ill-prepared for inflation and the risks of higher rates.
There is no shortage of pundits decrying doomsday prophecies. Admittedly, I don’t know when or by how much rates will change. I want to highlight the foibles of complacency in place after 30 relative easy years for bond investors.

Do bond investors even remember what higher rates do to the value of bonds? When this shows up on their statements in red ink, will they act on a rational plan or react emotionally? Will they wait too long to sell? Worse still, if they moved into bonds recently after being jilted by their stock investments, where will they turn next?

If and when this happens, the saddest investors on earth will be the ones who didn’t understand that bonds can be as risky as stocks.

Hoy Grimm

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