Bonds do have risks

By DAVID MOON, Moon Capital Management, LLC
May 1, 2011

Conventional wisdom sounds like this: If you want to grow your money, you must take risks. Stocks equal risks. Bonds are safe.

That was pretty good advice until the stock market fell apart in 2008. Even with stock prices now recovered from their 2009 lows, the S&P 500 still sits below its levels in early 2000.

An investment in the average long-term bond mutual fund would have more than doubled since then.

Remember that the next time someone tells you that you have to take more risk in order to make a higher return.

Another thing to remember is that in the decade prior to this eleven-year stock debacle, the S&P 500 increased more than 300 percent, significantly outperforming bonds. If you were making decisions on the basis of ten-year historic performance, in January 2000 you would have put all of your money into stocks – and then watched bonds outperform you for more than ten years.

So which conventional wisdom is right?

A recent AP story tried to assuage potential investor uneasiness over the municipal bond market. The prices of municipal bonds declined 4.6 percent in the fourth quarter of 2010, the largest three-month drop since 1994.

The article stated five reasons not to fear municipal bonds: default rates are historically low, bonds used to pay for public service projects are safe, diversified funds lower risks, the economy is improving and falling bond prices in the fourth quarter created bargains.

With the exception of the last criterion, all of these factors fall under the heading of “conventional wisdom.”

Historically low default rates do not guarantee low future default rates. Jefferson County, Alabama (home to the state’s largest city, Birmingham) has been facing the possibility of bankruptcy for three years. What was the white elephant that eventually pushed the county to a crisis state?

Sewer bonds – that is, a presumably safe public project.

Observers also blame Jefferson County’s problems on several former county officials convicted on corruption charges. Maybe I’m crazy, but I’m guessing that Birmingham doesn’t have a monopoly on corrupt municipal officials.

Bonds can and do have risks, even if it hasn’t been obvious during the past decade or two – and perhaps even because it hasn’t been obvious. Bonds have continued to generally increase in value for almost 30 years for the same reason the housing bubble developed: a government bias toward easy money.

Assuming a person doesn’t really have any investable funds until reaching age 30 or so, no current investor under the age of 60 has personally experienced a period of sustained increasing interest rates.

That doesn’t mean, however, that it can’t – or won’t – happen.

Seventy years ago today the Empire State Building became the tallest building in the world, a title it held until being dethroned by the World Trade Center in 1972. Conventional wisdom was that buildings stood forever, or at least for a very, very long time – especially a massive, multi-building complex like the World Trade Center.

As Nassim Taleb wrote in his fantastic book “Black Swan,” just because something hasn’t happened doesn’t mean that it can’t.

David Moon is president of Moon Capital Management, a Knoxville-based investment management firm. This article originally appeared in the News Sentinel (Knoxville, TN).

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