Bonds Are NOT Safe

Bonds are widely touted as “safe investments”. They are not.

Historically, stocks were seen as ‘risky’ and bonds as ‘safe’. This is because, if held to maturity, the bond is expected to pay out the entire principle. So even if your bond drops in price in the middle of the term, that price is to be paid in the end.

Especially in the aftermath of the latest stock market crash, folks have run in droves to the “Safety” of bond.

But bonds, especially as sold today, ‘have issues’. The first, and most obvious, is that in times of inflation that bond may pay you back full face value in 20 years, but only buy 1/2 the actual value. Holding long term bonds during times of inflation is a lethal combination, financially speaking. The second is the risk of default. How much do you think an Enron bond is worth right now?

So you have to keep in mind the default risk, and the risk of inflation. OK, any more?

Sovereign Risk

Historically, the bond holders get ‘first claim’ on assets of a distressed company, ahead of stock holders. When GM hit the rocks, the U.S. Government stepped in and screwed the bond holders. Obama’s administration decided to give a great big wet kiss to the Autoworkers Union (who’s contracts would be abrogated in bankruptcy) and instead gave them 1/4 or so of the company. Taking another chunk for the U.S. Treasury. “Soon” there is supposed to be a stock sale back to the public (called an “IPO” for Initial Public Offering… but I must wonder how ‘initial’ it is for a company this old). All the prior stock holders got the boot out the door with nothing to speak of; while the bond holders who ought to have gotten ownership of the company got nothing. They get to continue to take all the risk, uncompensated for it, while ownership passes to “The Friends Of Obama” club. Very “not good” to bond holder rights.

For any given bond, the national central bank for the currency in question can ‘monetize debt’ and cause inflation. The Federal Reserve also sets the interest rates. Between these two, they control the eventual value of the principal to be paid out AND the present market price for the bond. When rates drop, bond prices rise (If a $1000 bond is paying 4%, why pay $1000 for a new 2% bond? The old one will instead sell at a premium. Conversely, why pay $1000 for a 2% bond if rates on new bonds are now %4? So you will only buy it at a discount. And that ‘premium’ paid over face value will not be paid to you as principal at maturity, it is ‘in’ the interest rate valuation at the time of sale / resale.)

The Fed presently has interest rates at 0% to 1/4% (basic Fed Fund Rate to other banks). It’s hard to go lower than zero. So bond prices have jumped up. WHEN (and it is a “when”) The Fed starts to raise rates, those market prices for bonds will begin to drop. And it can be fast and hard.

The Chart

This is a graph of a 20 year bond fund. Notice that we have had a dramatic rocket ride up in bond prices lately as the Fed has cut rates. Then, at the end, a downturn as some good economic news made folks think maybe the 0% Fed Funds rate days are numbered.

The top chart is ‘static’ at a moment in time. The second chart is live, so you can see what’s happening now. You can click on these to get much larger and easier to read version.

Twenty Year Bond Fund TLT September Start 2010

Twenty Year Bond Fund TLT September Start 2010

The “Live” version:

TLT 20 year bond fund Live chart

TLT 20 year bond fund Live chart

Notice how the price rises in an accelerating nearly parabolic way? That is usually followed by a rapid fall, that we see happening / starting at the right side. We also note that the bottom indicator, DMI, has “Red On Top” now, that the middle indicator MACD has a ‘crossover to the downside” with the opening between the red and blue lines pointed downward. Also of note, Slow Stochastic said this trade was ending a little while back…

So for ‘some time to come’ the trade is to be out of bonds. How long? That will depend entirely on The Fed. They could buy $500,000 Billion of bonds tomorrow and spike the price back up, or they could raise rates to 1/4%-1/2% and drive them down. But the best bet is likely a bit of both activities, with time to gracefully exit bond holdings. It will take a year or so for the economy to get rolling really well, and not much is likely to be done until after the November elections. But I’d start easing for the exit now.

But Wait, There’s More!

Few individuals these days buy a lot of individual bonds. They buy a bond fund. For diversification. For built in ‘management’ as the bond fund does all the buying and selling. But this has a major major impact:

A bond FUND never matures

So when The Fed starts raising rates, you can not simply choose to ‘hold’ and eventually get paid your principal in full as a holder of an actual bond could do. Some of the folks in the fund will cash out and that quantity of bonds will be sold right then at market rates, never maturing in the fund. Any losses are locked in.

So holders of bond FUNDS really just have a bet on the direction of interest rates and the security of the lender.

And we know interest rates are not going below zero any time soon.

Conclusion

My conclusion is that it’s time to start easing out of bond funds before The Fed does the first rate hike. The present prices are nearing the SMA stack from the top side (so the best time to sell was some days back) and there is the chance they may make one more spike up before this is all over. (Markets often end with a ‘double top’ where prices try to regain past glory and fail to advance). It is unlikely to be a full fledged “rout” until The Fed actually does start raising rates. But it’s also pretty clear that the bulk of the party is over and the bulk of the risk is still in front of you.

Manage the Risk and the Reward will take care of itself. -E.M.Smith

And that means leaving this profitable trade while the reward is still in hand and while the risk can still be left for others.

Can’t stand the idea of CDs or stocks at the moment?

OK, you can always just “shorten the maturity”. Roll out of those 40 year, 30 year, even 20 and 10 year maturity bonds and bond funds and into 1 year or even 90 day paper. You still have the ‘full faith and credit’ of the issuer, but have much less interest rate risk. Short duration bonds do not respond much to rate changes.

And yes, this applies to “TIPS” too. (Treasury Inflation Protected Securities). The yield on them is down at a fraction of a percent anyway and you can do much better in good utilities or oil and gas trusts. But the chart tells the same tale. Time to exit.

TIP Treasury Inflation Protected Securities bond fund

TIP Treasury Inflation Protected Securities bond fund

RSI is having approached 80 hitting lower highs. DMI is “red on top” and MACD is “opening downward” after a crossover to the downside. Time to be gone.

Trader Talk

For hard core traders, “Time to be Gone” also can mean “Time to be Short”. This chart is the TBT, a vehicle that shorts long term bonds, but trades like any other stock ticker. So you could ‘flip’ your position from TLT to TBT and work both the up and down trends. Notice that the indicators here say to be in, with the crossovers happening to the upside after a long downward run.

TBT "Short sell" of long bonds fund

TBT "Short sell" of long bonds fund

RSI approached 20, then heads up. MACD doing a ‘crossover to the topside” and DMI is just about ready to be “Blue on top”. As long as MACD is below the zero line and while price is below the SMA stack, we have an ‘unconfirmed’ buy trade. I would expect price to cross the SMA stack to the topside (and perhaps then dip back down to touch from the top) while DMI goes clearly “blue on top” and MACD heads to over the zero line. Those all confirm the trade and tell you to stay in it longer. If those don’t happen, it’s just a dead cat bounce into a flat trendless vehicle. You can ride the bounce, but exit when Slow Stochastic or MACD turn against you…

About E.M.Smith

A technical managerial sort interested in things from Stonehenge to computer science. My present "hot buttons' are the mythology of Climate Change and ancient metrology; but things change...
This entry was posted in Economics - Trading - and Money and tagged , . Bookmark the permalink.

14 Responses to Bonds Are NOT Safe

  1. boballab says:

    EM

    To me the problem with the Bond market is one of the problems right now with the stock market: The Obama Administration.

    You can’t trust that the rules will be the same in 6 months as they are now with this crew based on his past performance via executive order (dictatorial fiat). The old saying of fool me me once shame on you, fool me twice shame on me comes into play. If you absolutely have to get into the market, just follow Sorros, Obama knows better then to try and screw him.

  2. Rob R says:

    Hi

    Big earthquake yesterday- Christhurch/Darfield area, South island, New Zealand. Potentially around $ 1 billion damage.

  3. Sinan Unur says:

    I never understood how people could talk about systemic risk on the one hand and bonds as “safe” investments on the other hand.

    After all, a mortgage is a secured bond ;-)

    PS: ITYM “principal” not “principle”.

  4. E.M.Smith says:

    @Rob R: See the posting a couple before this one, it’s about that quake.

    @Sinan Unur: I think it comes from the idea of buying and holding a US Treasury bond to maturity. That is “safe” in that the bond will be repaid. But then you start to get into the ‘special cases’ that erode that “safety”. Inflation cutting the value of the repayment, short term price excursions that you may not be able to just ‘ride out’. Non-government bonds that can default. Foreign bonds that have revolutions (for governments) and wars, and foreign corporate bonds in other currencies that can move relative to the dollar. And then you hit the bond fund, that never matures and that has the exact contents wonder over the years; often with forced sales and buys at exactly the wrong time. Yeah, “safe” is never a word to be applied to an investment vehicle in a traded market. And certainly not one dependent on government actions.

    Like the point about mortgages ….

    FWIW, yes “I knew that” ;-) Unfortunately there appears to be a large gap between “knowing” and “execution”… When I’m “in the moment” on a topic, the mind is focused on it with some ferocity and, unfortunately, to the exclusion of ‘trivial things’ that happens to also include spelling…(and bleeding…) I’m sure at some evolutionary stage the ability to exclude all the ‘clutter’ and focus on The Beast made a survival difference. Now it’s just a PITA. I’ve looked down to discover the back of my hand bleeding when working on vehicles. The cut was just not important and the focus blocked it until done. Last night while in discussions over a computer screen I discovered my reading glasses were back in their case in my pocket, having been on my nose a minute before. Three times in 1/2 hour. “Otto” put them away without bothering to tell me. You know, Otto-Pilot… I’d claim it was age related absent mindedness, but I’ve been doing it since at least 5 years old (and probably earlier, but that’s the first distinct memory of it I have). Part of why I’ve (self diagnosed) said I have “high function borderline Aspberger’s”. In college, I had a French class during a summer session. ALL of the French language was covered in 3 classes (1, 2, and 3) then you went into French Literature… It was the quarter system, so usually 10 weeks. 6 units. Yeah, a bit “intense”… But during the summer session this was shortened to 5 weeks (and one of THEM was finals week…) I happened to be working full time too… So I took French 2. 1/3 of all French grammar. 2000 or so vocabulary words (AND their funny spelling…) Several past tenses in the mix. It was intense and it was fun. But I never did get all the spelling right and it further screwed up my English spelling (that was none too swift to begin with). But that kind of thing is when I am most alive. Part of why I make a good programmer. As much as I complained about GIStemp, it was that ‘being in the moment’ of sucking it all into the brain that makes programming interesting. I just wish it had had some elegance or skill in it so as to provide some new skill. So now you know. I once read a 14 volume set of technical manuals cover to cover for a database product in about a month. Then became a ‘senior consultant’ on it for the vendor. Just don’t ask me to spell correctly…

  5. Rob R says:

    Spotted the earthquake post after I looked at this posting.

    The quake was quite strong on the west side of the South Island but not damaging. It woke everyone in our house, infact it woke everyone I have talked to in our town. One or two minor items fell off shelves at our place.

    There are lots of fault lines running through the South Island. This quake happened on a fault that was previously unknown. Sometime in the next 100 years we are expecting an earthquake of magnitude 8.0 or greater on the Alpine Fault (plate tectonic boundary that runs down the west side of the Southern Alps). When that occurs it will make the current one look rather small.

  6. David says:

    You did not mention I-Bonds. Mine are locked in at about 1.5 to 2%, and then ride with inflation after that. Currently yield is about 4%. Unfortunatley the Goverment has severely limited how much can be purchased.

    This is the bulk of my savings, and then a little stock, mostly dividend, a little gold, a little property. Not so brave as to really play this game. (The follow Soros comment may be relevant in this vey political world.)

    EM “Just don’t ask me to spell correctly…”

    To paraphrase a savant I know, “discerning the placement of a comma, does not account for an intellectual coma.”

  7. David says:

    P.S. I-bonds can be held for thirty years, are a direct obligation to the US treasury, can be sold after 5 years with no penalty, and sold before that with a 6 month? penalty.

  8. E.M.Smith says:

    Here’s a description of the I-bonds vs TIPS:

    http://www.treasurydirect.gov/indiv/products/prod_tipsvsibonds.htm

    There are two ways to get good a ‘playing the game’ without a lot of bravery needed. First is “paper trading”. Make a spread sheet and pretend to make trades. Enter the buy / sell based on the prices on Bigcharts (or other service) at the moment you decide to buy / sell. After doing that and making virtual money for 6 months, you will find that there is not so much fear left. The other method (or step two…) is to make small real trades. Buy $500 or $1000 of some very safe stock or fund. ( I like the ETFs for whole countries, like SPY for the S&P 500 or QQQQ for the NASDAQ 100 or even DIA for the Dow Jones 30 Industrials and EWZ for Brazil. But you can also use things like IAF for Australia (10% dividend right now) or even individual stocks that have large dividends like oil and gas trusts HGT 6.8%, PWE 9.5% , etc. or the pipeline and tankers companies like TGP 7% or BGH 4.9%.) They tend to be resistant to collapse (though will trade up and down) and if you “screw up” and forget to sell you end up with a ticker that pays more than your bonds anyway. If you are in this for a 20 year bond holding period anyway, do the math on what a 10% compound interest rate does to that yield… (IAF is managed to the goal of a 10% yield).

    At any rate, the I-Bonds are not a bad idea. They are like small “TIPS” (that I’ve suggested often) in that they have an inflation protection kicker in them. They just don’t pay very much, but you get to ignore taxes and reporting until you cash them in. Good for folks with small holdings who don’t want any complications. Since they are not market traded, you don’t get the market fluctuations of principle with interest rate changes. A very reasonable choice for folks not wanting to buy TIPS and with less than $5000 / year to put away.

    The one risk they do still have is ‘exchange rate risk’ in that someone living in, say, Japan with a rising Yen would be seeing the dollar value of the bond drop compared to the yen. Not a big deal if you live in the USA… The inflation rate ‘kicker’ in them takes care of the biggest problem with bonds long term.

    So someone holding I-Bonds does not have the same kind of problems as someone holding a bond FUND invested in corporates or 30 treasuries. (And lord help them if they are in municipal bonds of bankrupt states and the state decides to default.) Things with no inflation kicker and with no printing press to avoid default.

    So I’d not be in a big rush to trade out of I-Bonds; since they don’t trade. They are more like inflation protected cash. Your biggest risk is that the congress might redefine the CPI and make your inflation adjustment wrong. (They did that back during the Regan years, so it’s been done before. To some extent, IMHO, the CPI of today is better than it had been but now does slightly under report actual inflation. Just not to a major degree.)

  9. Sinan Unur says:

    @E.M.Smith: To clarify, I wasn’t trying to be the spelling police. It is easy to overlook something like this, so I wanted to give you a heads up.

  10. E.M.Smith says:

    @Sinan: I know. And I do appreciate it. But thought it was worth pointing out that some of us have brains that work differently. As I’ve said before, one of my joys is reading old writings where they spell most wonderfully. You can hear the difference in their voices as they spell in keeping with the ear, not the phoneme. (English has phonemic spelling – based on the function of the part of the word, not the sound, the ‘idea group’ if you will. In many ways better than phonetic that just gives the sound profile, as it preserves the history better. But it is a straight jacket at times… So oral and aural have very different meanings encoded in the spelling, but sound the same to us in the USA today. Yet O-ral vs Aw-ral sound different in British English thanks to the “caudal au”. So ought it to be spelt the same in both cases? (Or “Should it be spelled the same in both cases?”…)

    So while I appreciate the “tip” so I can correct a public faux pas; I also like to point out that spelling wern’t allsways so tite arsed. Basically, I’m on both sides of the street on the issue, so enjoy filling in the missing bits.

  11. Gnomish says:

    The best spellers acquired their vocabulary by reading.
    I know some words I’ve never even had occasion to pronounce.

    Tiny keyboards on phones are necessarily altering the syntax and spelling, too. Language is dynamic. Even definitions change – sometimes 2pi radians.

    That said – I freakin love the OED for NOT changing definitions to suit fashion. Standards are good! Principles would be better, but there was no King Sejong of the western world.
    If you don’t know about King Sejong – he’s one of the minor gods in my pantheon:
    “Numerous linguists have praised Hangul for its featural design, describing it as “remarkable,” “the most perfect phonetic system devised,” and “brilliant, so deliberately does it fit the language like a glove.”[19] The principal reason Hangul has attracted this praise is its partially featural design: The shapes of the graphs are related to the phonemes they represent. The shapes of consonant letters are based on the shape of the mouth and tongue in the production of that sound, sometimes with extra marks showing features such as aspiration. In addition, vowels are built from vertical or horizontal lines so that they are easily distinguishable from consonants.”

    Children could learn to read in a matter of hours.
    What was written then can be pronounced as then – today.
    The syntax was grammatical too. Thing of beauty, eh?

  12. PhilJourdan says:

    I am glad you referenced the GM extortion. If nothing else, the Obama bailout of GM and Chrysler should warn people that as long as you have a government that is not governed by laws, nothing is safe.

  13. E.M.Smith says:

    @PhilJourdan:

    That one act put a chill on ALL bonds other than treasuries. The whole hedge fund market of take-outs just walked away. WHY would I buy all the bonds of future GM expecting to be able to get the company, fix it, and put it back on the market repaired; knowing the whole time that the Government would simply screw me out of Billions?

    That will put a pall on corporate bonds from weaker parties for decades to come. (Though I can see some good things about it, in that executives of such companies will be less inclined to jigger the capital structure to screw the stock holders in exchange for cash via bonds to excess when such bonds are not salable.)

    But the bottom line is that the Federal Government has said the rule of law can not be trusted, and the game has variable rules. And that says “Take your money and run”. Head for a country without such ‘flexible’ laws…

    It also makes stock more risky in that if the bond holders got screwed, it’s even easier to screw the stock holders. They got nothing. So any large corp that MIGHT be able to get some more capital via bonds while the stock drops to $1 and maybe some day recover some value for the stock holders (i.e. not quite go bankrupt) will now have folks dumping both stock and bonds like crazy WAYYY earlier.

    Just what you need to get the stock market working again… /sarcoff>

  14. E.M.Smith says:

    Two “Polish Points” on the bond short trade. And one major “gloat” ;-)

    First, This has been one rather nice call if I do say so myself. Out right on time, and a nice gain on TBT as bonds have fallen.

    There is likely a lot more to go in this trade as eventually The Fed has to start raising rates. But that is unlikely during an election month or the months leading up to it. That trade is more of a years long trade.

    At this point we do NOT have a confirmed ‘bear market’ in bonds, only a “reversion to the mean”. So prices have dropped back to the moving average lines and Slow Stochastic is down near 20 on TLT. It’s a ‘possible’ that the price will hold at that point before eventually punching through the SMA stack (and when that happens, it will return to the SMA lines from below and fail to punch back through to the upside, that is the ideal safest time to do another short).

    We also have the Bank Of Japan promising to flood the market with Yen to chase folks out of it (in a push to make Japanese manufacturing more competitive – the high yen is hurting…) This means a fair number of folks will be chased out of Yen and looking for some other ‘safe haven’. Most of that money seems to be headed for gold and silver, but some of it will likely land in bonds while they think about what to do.

    The point?

    If you’ve made a bundle on this short of bonds via TBT, this would be a good time to take some of that money off the table. Bank some gains. Reduce the risk. There will be time to get back in if you want to play that run some more.

    So look at that TBT chart. At present, we’re trading a return to the SMA stack from the bottom. We have to get the SMA lines to weave and price to cross over to the topside before we can say the longer term TREND is clearly in our favor. For now it’s just a ‘counter trend rally’. And rules are rules. And the rule for a counter trend rally is to get out at the SMA stack. If you have conviction that this really is the start of the fall of the dollar and that folks globally will be dumping bonds like crazy any day now, you could just put a snug stop loss order behind the TBT position and let market action make the decision to sell for you (or the decision to stay in and ride some more…)

    But in all cases, protect those gains. Don’t let a gain turn into a loss. Ever.

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