How Safe Are Bonds? Warnings for a Mom Who May Be Getting Bad Investment Advice

BY Paul Solman  September 12, 2012 at 7:36 AM EDT


Stacks of one hundred dollar bills pass through a circulator machine at the Bureau of Engraving and Printing in Washington, D.C. Photo by Andrew Harrer/Bloomberg via Getty Images.

Paul Solman answers questions from the NewsHour audience on business and economic news here on his Making Sen$e page. Here is Wednesday’s query:

Name: Wamtech

Question: My Mom is 83 and has $40,000 in mortgage-backed bonds. A finance advisor suggests moving this $40,000 and $60,00 which is in the bank and invest all moneys into corporate bonds making 5 to 6 percent interest. He says it is a safe investment, and she has access to the money anytime she will need it. With interest rates at record low levels, what are the situations where she could possibly lose money in corporate bonds?

Paul Solman: It’s startling to hear that an 83-year-old is holding $40,000 in mortgage-backed securities. If she’s got a million or more socked away, it could be seen as “mad money.” But if it represents a significant portion of her financial assets, it seems like a mighty risky position. I admit that there are many levels of risk, depending on the nature of the MBS she holds. But I must say: I’m suspicious. Does she know the details of the securities? Do you? Why wouldn’t she be in a low-cost bond fund instead of holding actual securities, save for the fact that it’s more profitable for a money manager to sell them to her?

Let me repeat something I’ve written here before, but which can’t be emphasized too often or too strongly: two iron rules of investing are diversification and low cost. That means buying mutual funds, not individual securities, and making sure those funds have the lowest possible management fees. It doesn’t sound like her “finance advisor” is doing either. This worries me. It should worry you.

But on to your question. What situations pose risk for corporate bonds? The same two situations in which she could lose money on those mortgage-backed securities she’s got: 1) the borrowers can’t pay back the money that was loaned to them when they first issued the bonds and so the bonds sink in value; 2) rising interest rates.

Your mother can reduce, if not almost entirely eliminate No. 1 — default risk — by investing in a heavily diversified portfolio of bonds in a bond mutual fund. So let’s suppose she’s wise enough to listen to you, who are wise enough to listen to me. She therefore gets her current finance advisor, or a new one, or you, to buy shares in a bond fund. (I feel better already.)

But — she would still be vulnerable to situation No. 2: rising interest rates. In fact, because interest rates are at “record low levels,” as you put it, the risk is now greater than ever. Since interest rate risk is the danger of investing in bonds of any stripe — mortgage-backed, corporate, municipal or Treasury — let me spell it out in detail.

Say your mother is advised to buy $100,000 worth of corporate bonds paying 5-6 percent a year, like the Goldman Sachs Medium Term Notes that I recently looked up and mature (come due) on June 15, 2030. The notes (IOUs) were paying 5.5 percent and you could buy them at “par,” which means at the face value of the bond: 100 cents on the dollar. So in this case, your mom would pay $100,000 for Goldman Sachs bonds that come due in 18 years, at which point they promise to pay their face value: $100,000. That’s the principal, the amount that was loaned to Goldman Sachs in return for these IOUs, aka notes or bonds.

With me so far? Good, because now comes the counter-intuitive twist that makes bond pricing so hard to understand.

When these bonds come due, your mom will be 101. Quite conceivably, she or you will want to sell them before then. That sale will occur on the bond market.

Now imagine that, between the day you buy the bonds and the day you sell them, interest rates rise. To make the point, let’s say they rise dramatically. Goldman Sachs — and every other borrower out there — would then have to offer a much higher rate of interest in order to entice lenders to part with their money. So the new Goldman Sachs bonds — or mortgage-backed securities, or corporate bonds in a bond mutual fund even — are now offering, let’s say, 10 percent interest.

If a new bond from a borrower like Goldman Sachs offers 10 percent a year, what do you suppose happens to the value of an old bond from exactly the same borrower offering 5.5 percent?

The old bond drops in value. All old bonds drop in value. It’s counterintuitive but it’s true: when interest rates go up, bond prices go down — because the old, lower-rate bonds are worth less than the new ones that pay a higher rate of interest. So the dangerous situation is that interest rates rise, and the value of current bonds, like those your mother has invested in, sink.

This doesn’t mean that your mom shouldn’t invest in bonds. To my mind, they’re still safer than the alternative investments out there these days, and most of my own portfolio is in bond mutual funds. I repeat: Mutual funds.

But my main advice with respect to your mother: get a second opinion from a different financial advisor. Right away.

As usual, look for a second post early this afternoon. But please don’t blame us if events or technology make that impossible. Meanwhile, let it be known that this entry is cross-posted on the Rundown- NewsHour’s blog of news and insight.