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Are You A Bond Market Lemming?

Over the past year, a record amount of money has flowed into the bond market. Whenever you see record inflows into any asset class, that's usually a bad sign. Remember that record amounts of money poured into technology stocks just before the 2000 crash, and people were shoveling money into housing just before the bottom dropped out. So are you in for some big losses in the bond market?

Well, bonds are a lot different than these other asset classes. So if you've been adding to the bond market with a clear strategy, then you'll probably be just fine But if you've been throwing money into bonds without understanding what you're buying, then you may be in for a rough ride.

The Difference. Here's the big difference between bonds and stocks (or housing for that matter). When you buy a stock, you have no idea what that stock will be worth in the future. So if you pay $100 a share at the peak of a valuation bubble, it might only be worth $30 a share 10 years later (see the price of many prominent tech stocks). Or if you buy a home for $600,000 at the peak of a housing frenzy, it might only be worth $300,000 a few years later (see Florida, Arizona, California or Nevada).

But if you buy a new bond for $1,000 today and it matures in 5 years, what will it be worth? Well, $1,000. That's the whole point of fixed income; it's fixed. You know the starting value and the ending value. And in between the time you buy it and when it matures, you get an interest payment, which is nice. So what's all the fuss about a bond market bubble.

The bubble issue comes down to the nature of changing interest rates in the bond market. If you buy a bond when interest rates are low, then you'll get a low rate of interest until it matures. The risk is that if interest rates go up, you'll lose out on an opportunity to have earned more interest. But you still made money on your investment. In fact, you got the exact deal you contracted for. And if you have some bonds maturing every year or so, then you always have new money to invest and adapt to changing interest rates.

You can essentially follow this strategy by building your own bond ladder, or using passive bond funds or ETFs that simply attempt to replicate the return of various aspects of the bond market. While there are some technical issues on how passive bond funds and ETFs match up their holdings with the index holdings, the result should be roughly the same as a laddered portfolio with the same objectives.

So if that's how you've been approaching the bond market, then you're probably going to be just fine.

The Problem. The problem comes when bond investors try to time the movements in interest rates. You see, as interest rates change, the value of a bond can move pretty significantly. It's a little complicated, but essentially bond prices are adjusted every day as interest rates change. If rates go up, the value of bonds will go down. Again, the decline doesn't really matter as long as you intend to hold the bond until it matures. That's a temporary valuation change, not a permanent loss.

But these price changes matter a lot if you're trying to make money off those movements. By betting on interest rate moves, you can take an investment that is pretty safe and turn it into something that is quite risky. This is where the problem lies for many bond investors.

Many bond managers attempt to make money off the movements in bond prices, and this requires managers to accurately predict future interest rate changes. If your bond manager makes a bad call and takes a dive off the interest rate cliff, you could end up following him.

So how do you know if your bond manager might be exposing you to bigger trading risks? Here are a few things to consider:

Turnover. If your manager has high turnover, then the manager may be attempting to time interest rate movements, which again can be quite risky if the manager makes the wrong bet. And by definition, many managers will make the wrong bet because they can't all be on the right side of the interest rate trade. You might be surprised to learn that some big bond funds have turnover in excess of 200%. If you see high turnover, you should investigate why.

Hedging and Leverage. If your bond fund manager is using hedging instruments or is taking on any sort of leverage, you should be concerned. At their core, bonds are pretty simple. But Wall Street has a tendency to complicate everything. And the more complicated the manager's trades are, the more likely the manager is to make a mistake.

  • You might be wondering why bond managers complicate things. In short, they're trying to reduce or eliminate the decline in bond prices that would result from rising rates. Instead of accepting that this is how bonds naturally work, they institute complicated trades to try to offset the decline. If the trades don't work as expected, you could end up with permanent losses as opposed to temporary price declines.
High-Yield. If your bond fund is invested in high-yield bonds, that basically means you're loaning money to companies with lousy credit. Not generally a good idea. You see, nobody pays more interest than they have to. So why do you think some companies pay high interest rates? Not because they're charitable. It's because they've got bad credit and can't get a loan at a lower rate. So if you're looking for safety from your bond holdings, it's a good idea to be confident your bond fund is investing in high credit quality borrowers. If not, when rates rise, it could cause all sorts of problems for sub-prime (I mean high-yield) corporate borrowers.

International. If your bond fund is invested in international bonds, you have to understand what risks you're taking on. If you own debt of a country that is experiencing credit troubles, you could see declines beyond what you anticipated. Moreover, international bond funds are generally subject to currency risks. The currency market is wild, and changes in currency rates could have an adverse impact on your bond holdings.

  • Now, you may have invested in international bond funds for diversification purposes, but that's a lot different than investing in them for stability and safety. Make sure you know why you own them.
Bottom line. Don't jump into the bond market without understanding what you own. Some bond funds may be exposed to a lot more risk than you're prepared to handle. When in doubt, keep it simple.

Consult your individual financial advisor prior to making any investment decisions.
Learn More: Want to learn about a simple way to manage your personal finances and prepare for retirement, investigate my new book Your Money Ratios: 8 Simple Tools For Financial Security, available in bookstores and at amazon.com The Wall Street Journal called the book "one of the best finance books to cross our desks this year." WSJ 12/19/09.