Both risk averse and yield-hungry investors who have created a bubble in the market for bonds ? including both US Treasuries and corporate junk bonds ? are in for a rude awakening if things do not go just right, according to an August 22, 2010 InvestmentNews article, “The dangers of the growing bond bubble.”
The bubble is most pronounced in US Treasuries. Investors seeking a safe haven have caused bond prices to rise and bond yields to fall to record levels. Five-year Treasuries are yielding 1.38% – down from 4.43% in 2007, 2.80% in 2008, and 2.2% in 2009. Ten year Treasuries are yielding 2.56% – down from 4.63% in 2007. Thirty year Treasuries are yielding 3.71% – down from 4.84% in 2007. Thirty years is a long time to tie up money at 3.71% with so many members of the Federal Reserve so concerned about inflation.
The Federal Reserve will have to accomplish a minor miracle to prevent erosion of the dollar’s purchasing power despite its huge injections of liquidity into the economy. But many investors are more concerned about return of investment than return on investment, according to the article.
Unfortunately, if interest rates rise, and investors are forced to sell their bonds, they will suffer a loss of principal. Even if they hold to maturity and receive 100% of their principal and interest, that sum may be worth less than what they invested.
Those most in danger, however, are holders of junk bonds and junk bond exchange-traded funds. Investors could be damaged not only by rising yields but also by defaults in a slowing economy. Junk bond investors must hope for a Goldilocks scenario ? not too hot (inflation), not too cold (deflation).
Despite this risk, demand for junk bonds has driven yields down, as they are still significantly higher than Treasuries or investment-grade corporate bonds. Ten year investment grade corporate bonds are yielding about 2.84%, but many junk bonds yield more than 7%.
Investor should not get carried away with bond investing in current market conditions. There are substantial risks in the market especially with junk bonds. Investors should expect a full explanation of such risks from any financial advisor recommending bond purchases.
Page Perry is an Atlanta-based law firm with over 125 years collective experience representing investors in securities-related litigation and arbitration. While past results are not indicative of future success, Page Perry’s attorneys have recovered over $1,000,000 for clients on more than 30 occasions. Page Perry’s attorneys have extensive experience in representing investors in bond investments. For further information, please contact us.