Bond Market Crash Coming?

No matter where I go or what I read there always seems to be scary news about bonds. Bonds seem to go hand in hand with words like “Crash” or “Bear Market.” A bond market crash never seems too far away. If we paid attention to all this, it would never be a good time to buy bonds. However, I think in reality this couldn’t be further from the truth. If you have a properly diversified portfolio a bond market crash shouldn’t be anything to worry about.

What are bonds anyway?

Buying bonds is a bit like getting a loan from the bank, only this time you are doing the bank’s job. You lend money to an organisation (a company or a government) and they agree to pay you back all your money at a certain date. Furthermore, in the meantime they pay you interest for your trouble. You don’t have to worry about the value of your bonds going down either. As long as you keep your bonds until the agreed date you’ll get all your money back. On top of this, you’ll have made money through all the interest you’ve been receiving. So what if there is a bond market crash! Sounds great, right?

Going bust!

Before you go and invest all your money in bonds there are a few things to think about. Firstly, however unlikely, the organisation you are lending your money to might go bust. If that happened you’d more than likely lose all your money. A bond market crash might no do you any harm, but the company you’re lending money to could.

The way technology is changing the world around us, who knows which companies are still going to be here in the future. Even governments money situations can change. At the time of writing the bonds which are perceived as safest are the governments of the US, UK and Germany. However, at the same time the UK is dealing with Brexit, Germany has problems with the European Union and the US seems to be constantly putting out fires both home and abroad. Who’s to say one of these countries won’t run into serious money problems in the next 20 years?

Inflation and duration

The second problem bonds face is inflation or put simply rising prices. Rising prices can cause a country’s central bank to raise interest rates. That’s not good for bonds because it means new bonds will have higher interest payments. This will cause the price of existing bonds to go down. Basically, you could lose money if you sold them or if you needed your money back early. Who would buy your bond for its original price, when they can buy a new one for same price paying more interest?

On top of this, inflation also causes the real value of the bond to go down. For example if your bond is paying 5% annually but inflation is 7% your interest payments are giving you a real return of -2%. That’s not a good way to make money. If a bond market crash comes, it is likely to be because interest rates are going up.

ETFs

Luckily there is way around both these problems, and that’s to buy short term bond exchange traded funds (ETFs). Maybe we can’t be sure that the US Government, the UK Government, Google or Apple will be in position to pay us back in 20 years, but we can be pretty confident three of the four will. ETFs contain a basket of bonds from hundreds of companies or organizations allowing us to spread risk by avoiding putting all our eggs in one basket. Similarly, interest rates aren’t likely to go shooting up in the short term. On top of this, in an ETF the bonds are continually being replaced with new bonds with higher interest yields. Thus, enabling investors to keep up with inflation.

There is also another option to deal with inflation. You could buy an ETF with inflation linked bonds where the interest yield is actually linked to inflation. If inflation goes up so does your interest yield. Of course if it goes down your yield would go down too, but then again so would the price of things.

Yield vs Risk

The safest bonds you are going to be able to get are developed world government bonds with short maturities or inflation protected bonds. Bonds with the most risk attached to them are likely going to be long term from lesser known companies who are not perceived to be in the best financial position. However, as risk increases so does bond yield, meaning the bond of the lesser known company with a questionable financial situation is likely to yield a lot more than the short term government bond. It is all a trade off between risk and return.

Because you can get better returns from corporate and long term bonds, there are always going to be people who advocate adding them to your portfolio. However, for most people the bond section of your portfolio should be as risk free as possible. Moreover, if you really want to take on more risk, you can increase how much of your portfolio you allocate to stocks. A portfolio comprising stocks on one side and short term bonds, inflation protected bonds, or both on the other side should provide a great portfolio.

Long term government bonds

There is one last thing to think about and that is the argument for adding longer term government bonds. In the past it is these that people flock to in times of crisis. They are likely to increase in value as stocks plummet and as people look for a safe place to store their money. Of course there is a trade off between how much of these you add and the risks associated with interest rates. An easy option would be to add a government bond ETF to your portfolio containing all maturities. That way you’ve got all your bases covered.

Diversification

Some people recommend an inflation protected bond fund, some a standard bond fund and some like David Swensen (the Chief Investment Officer at Yale University) recommend both. Adding both can only increase your diversification, which in turn should reduce risk. Thus, if you buy a couple of government bond ETFs with differing maturities, ensuring one is inflation protected you should be pretty diversified. For expats, the government you choose is likely going to be the country you intend to retire to, but if you don’t know where you want to retire to or you want to add an additional layer of diversification to your portfolio you can choose global funds that contain government bonds from different developed countries.

The bottom line is. If you have a properly diversified portfolio and a long term time horizon a bond market crash shouldn’t be anything to worry about.