The Riskiness of Bonds

Yesterday I questioned the wisdom of retail investors buying bonds in this market, and boy did I get an earful back, especially from many of the commenters at Seeking Alpha. They accused me of not drawing the distinction between Treasuries and credit, and of not appreciating the record spreads being seen in the bond market.

This morning, Henry Blodget gives us a useful chart, showing that the Lehman Aggregate bond index -- which is the benchmark for most of the bond funds that retail investors buy -- rebounded sharply in the last two months of this year, and ended solidly in positive territory. Which is quite an achievement for any asset class in 2008.

Now yes, the rebound is largely a function of the Treasury bubble -- but so are record spreads in the credit market. And since retail investors don't short Treasury bonds, they can't play spreads. Instead, they have just three choices: going long Treasuries; going long credit; or some combination of the two.

Clearly the Treasury market is treacherous right now, and could implode as quickly as it rose. I can assure you that this kind of chart (from a very useful blog entry by Richard Shaw) is not the kind of thing that dealers in US debt ever expect to see:

Yes, that's a 35% annual return on long-dated Treasury bonds, in a year which started with pretty low interest rates. So clearly anybody buying Treasuries right now is doing so at extremely frothy levels.

But what about credit? The flip side of Treasury outperformance has been a collapse in prices of credit, and in general the riskier the credit, the more it has fallen. Junk bonds and emerging-market debt cratered in 2008, but the bulk of the bonds that retail investors are likely to buy -- US investment-grade corporate bonds -- actually staged quite an impressive rally at year-end.

If you believe that mid-October's bond-market panic was overblown and that we'll never see such levels again, then feel free to dip a toe into this market. But if you do so, be clear that you're entering into a speculative trade: you're not putting your money in a safe place like an FDIC-insured CD. (And you can do that with any amount of money, not just $250,000, thanks to CDARS.)

But bonds certainly aren't any kind of hedge against stock-market underperformance. If the stock market goes down from its present levels, it will do so because of a wave of defaults wiping out the equity in a wide range of companies. The bond market is pricing in an uptick in defaults, but no one knows just how much of an uptick, and there's a very good chance that if a few large and heavily-indebted public companies go under in quick succession, the bond market could lurch back down to its October lows and possibly even fall further still.

None of this makes investing in bonds a bad idea for a sophisticated investor: they do seem to be more attractive, from a risk-return standpoint, than stocks, just as they have been since the summer of 2007. And there's a strong moral hazard play right now as well: there's a very good chance that Treasury will step in to prevent America's largest companies from going bust. But if you're looking for safety, cash is still very much your friend. And if you're investing in bonds, know the risks that you're taking.

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