A Reminder to All Investors: Bonds Are Not Safe

The June upheaval in the bond market shows what we should have known all along: There is no such thing as safety.

FROM THE ATLANTIC | JULY 11. 2013

The old stock market cliché "sell in May, and go away" had so far proved untrue this year. Instead, it is the bond market -- so often perceived as steady, low risk and dependable -- that has bitten investors. In fact, June was one of the worst months for bonds in many years. The declines were steep enough to serve as an acute reminder that nothing, and I do mean nothing, in the financial world is without risk.

Stocks have been rising with volatility for more than four years. Yet money has poured into bonds. That reversed dramatically in June, with investors pulling $28 billion from bond funds, the most since monthly records began in 2007. Pimco, one of the largest bond managers in the world, saw its normally staid and stable Total Return Fund drop by 2.6 percent, and investors yanked $14 billion from Pimco alone.

The proximate cause was the meeting of the Federal Reserve and the subsequent statements by Chairman Ben Bernanke. Bernanke said that if the U.S. economy continues its gradual path towards strength and stability, the Fed would consider ending its purchases of $85 billion of bonds per month. Those statements accelerated what had begun a few weeks earlier, namely a sharp rise in interest, with yields on U.S. 10-year Treasuries rising above 2.5 percent after they had been hovering around 1.5 percent.

The other cause was fear that China's shift from an economy based on exports and infrastructure to one grounded in domestic consumer activity would result in much weaker activity for the near future. That, combined with interpretations of Fed policy, led investors to sell so much emerging market debt that some prices dropped close to 10 percent in a matter of weeks.

Ever since the 2008-2009 financial crisis, the financial world has been driven primarily by fear and risk-aversion. Wealth managers will tell you that clients who wanted double digit returns in the 1990s and 2000s have gone from obsessing about "return on capital" to "return of capital." Pension funds, which account for trillions of dollars of investing activity, are caught in a multi-year bind between their obligations and over-optimistic return assumptions. Their boards have been focused on at least retaining the assets they have. The net result is that bonds, and especially U.S. Treasuries, have been seen as the ultimate safety.

What the June upheaval in the bond market shows, however, is what people should have known all along: there is no such thing as safety.

Bonds, however, are routinely touted for just that. Go to Investopedia, one of the more popular online resources for investing, and you will see an entire article under the heading "Why Bonds Are Ideal for Safety and Income." Investors of all stripes will routinely assail the stock market as a casino, view real estate skeptically, and then state a preference for municipal bonds or U.S. government debt.

What June showed is that bonds represent a safety bubble. Yes, the word "bubble" is bandied about these days to an absurd degree. But in terms of bond sentiment, it is merited. The only other asset that approaches the safety mania is gold, and we have seen gold in the past months plunge more than 30 percent. The bond market is many times larger than the gold market, with global bond holdings in excess of $60 trillion, and while vast swaths of it represent legitimate, measured government financing and corporate financing, far too many pension funds, individuals and sovereign wealth funds treat bonds as a slightly juiced proxy for safe money with a little bit of yield.

They aren't. And they never really have been. Bonds are simply another financial instrument entirely dependent on the integrity of the financial system. As James Carville famously remarked in the 1990s, "I used to think if there was reincarnation, I wanted to come back as the president or the pope or a .400 baseball hitter. But now I want to come back as the bond market. You can intimidate everybody." Bonds may be contracts between lenders and borrowers, but they also function as any other financial instrument in that they are sold, priced and traded like stocks and derivatives, and the community doing the selling, pricing and trading is small, insular and not always rational or functional.

This is why when the Fed whispers that its policies may shift -- a shift that most people expected -- trillions of dollars begin to flow in a matter of weeks or even days, as the larger players in this game attempt to price the next new thing. If such realignments go smoothly, it's no big deal other than some incremental pain or gain. But when they don't, as happened in 2008, again in 2009, and then with Europe and Greece in 2011, watch out. All of those financial crises stemmed from the supposedly safe and dull credit and bond markets.

The answer, however, is not to seek ever more exotic safe havens. Gold has proven to be fool's gold. At one conference I attended for high-net worth investors, there was an entire session devoted to investing in coconut plantations, because even if the global financial system implodes, people will need food and oil. All true, but still it's a stretch to believe that when the system collapses, coconut owners will be the ones with the last laugh.

The search for riskless investing is like the search for the fountain of youth, alluring but ultimately fruitless and worse, a trap. The quest for safety in investing is the financial equivalent of the quest for safety in general. Governments go to excessive lengths to provide total safety, and so does the financial world. The problem is the quest itself. Risk is part of the sea in which we all swim. You can have too much, but you can't have none. June was a wake-up call. Embrace risk, and you will probably do well in this world. Try to avoid it, and you will bring it on.

Source: https://www.theatlantic.com/business/archi...