The "I Thought Bonds Were Safe" Fallacy...

My dad called three times yesterday to see if I got his email.

“Did you see the video?” he asked.

Finally, at 11:30pm I had a few minutes to check my email. Here’s what the hoopla was all about…

Turns out my dad wanted me to see a video my mom took of him, swinging his golf club on the 7th hole (conveniently located just steps from his back porch.)

As it were, he was a little over-excited to show me a video of golf swing. But that’s not where the story ends…

You see, my dad is your typical retiree… he golfs a lot, is picky about where he eats and worries about his investments. I hear about it ALL in our frequent conversations.

Golfing comes easy. He recently moved south from Baltimore to a more temperate climate — no snow to shovel, there! With a golf course behind his house he can even get a few swings in for free, hence the video. As it stands, he gets to tee-off two or three times a week.

He’s also your typical retiree in the sense that he has a lot of his wealth tied up in mutual funds, some of which, of late, are bond funds.

“I’m getting killed this year in my bond funds” he told me recently.

“They were supposed to be safe” he said, while pulling up the performance on the computer. “Yeah, the 10-year return was [blah-blah percent…]”

That’s when I cut him off. Golf swing and early bird specials aside, it was time to have a frank talk about fixed income and bonds. In particular, I wanted to pull the curtain back on this year’s bond action — for my dad and for you…

Bond Funds: Like Putting Lipstick On A Fox

I remember years back when my dad would show me his investment choices. IRAs have limited choices — especially when you boil it down to those that are meant to be “safe.” He always wanted me to look at his bond funds.

A quick look into any bond fund will bring you to the same conclusion: bonds aren’t as straightforward as you think. Point is, unlike your father’s stack of paper war bonds, we’re not talking about buying a piece of paper from the government and locking in a safe, long-term payout.

Indeed, the way most brokerage houses pitch their bond funds, it’s like putting lipstick on a fox. Sure the returns look safe, but beneath the initial look the market is as sly as the best of em.

You’ve got to remember, unlike buying and holding a government or corporate bond, when you invest in the bond market prices can drop just as easily as they can rise. The bond market doesn’t always pay you fixed income like a bond. Sure, some funds may pay dividends, but if you are investing in bond funds — and not a bond itself — the market can go both ways. Up and down.

Plus, there’s a common misconception that the bond market is “safe.” For starters, as any investment great will tell you, NO investment class is “safe.” Unlike buying a bond itself, the bond market is a derivative (yep, the “D” word.) That is, the bond market dances to the beat of its own drum, unlike your father’s T-bond.

“I’m Getting Killed”: What the Heck Happened To Bonds This Year?

So what happened? Did the government default? Did someone break into the bond fund and steal the stacks of paper? Nope!

In short, Ben Bernanke’s comments created the recent melt-down in bonds.

His comments about the market and the future of the Fed’s easing program suggest that interest rates may soon rise and Fed bond purchases may be curtailed. When will this actually happen, if ever? Your guess is as good as mine.

But reality doesn’t matter here. It’s the expectations that matter. Bernanke’s comments spooked the market. That is, up until the April/May 2013 Federal Open Market Committee (FOMC) meeting, all we’d heard was that the Fed’s zero interest rate policy (ZIRP) and bond purchasing to the tune of $85B a month would continue indefinitely.

As of April/May the rhetoric changed. After years of dollar-be-damned policy, there was finally a set of comments that led investors to believe the Fed would start tightening its monetary belt. Again, when this will happen, if at all, is all up in the air.

But, when Bernanke speaks, bond markets listen. Since May 1st (the time of FOMC meeting), the value of long-term bonds, on the bond market, have been plummeting.

The reason for this is simple. Once Bernanke implied higher interest rates were on the way, the bonds that many “bond funds” were holding instantly didn’t seem as valuable as they did days before the rhetoric. That is, if you buy a 30-year bond at 3.5% and then Bernanke comes out and says rates may rise, let’s say to 3.75%, all of a sudden the 3.5% bond, in the eyes of the market, is a loser. That is, who would want a 3.5% bond for 30 years when you could have a 3.75% one?

The Bond Market Broke

Now remember, Bernanke didn’t change rates, he just implied that rates may increase in the future.

The market, however, took that rhetoric and ran. Accordingly, the bond market fell. For instance, from its high around May 1st the 30-year treasury market has fallen some 9%.

Nine….freaking….percent. That’s a huge move for a seemingly steady and professional market like bonds. It’s also a devastating move to risk-averse bond investors (like my dad.)

All said, safety seekers got burned. And you can thank the “Ber-nank.”

Tomorrow I’ll check in with my two cents for how to play this bond fiasco. Till then…

Keep your boots muddy,

Matt Insley
Original article posted on Daily Resource Hunter

The Daily Reckoning