Thinking About Buying Bonds? Don't Overlook This

When investors ponder the purchase of bonds, the prevailing thought that comes to mind is "conservative." While stocks can be volatile, bonds are much less so.

Less volatility generally means "less risk," and that is certainly the way academia describes it. The term volatility generally refers to the likely percentage move in value over the course of a year (up or down). There's even an index -- the VIX -- which measures investor expectations of volatility based on the price they are willing to pay for index options.

While most people are familiar with the stock market VIX, there is a bond market VIX out there as well.

Chart and list of interest rates

Image source: Getty Images.

If you compare the Cboe Global Markets S&P 500 VIX (which measures stock market volatility) versus the Cboe 7-10-year Treasury Bond Volatility Index, you can see that the volatility for bonds is much lower. 

^VIX Chart

^VIX data by YCharts

There is a huge difference between stock market volatility and bond market volatility at the moment, which includes more than just the gross numbers. While the stock market could theoretically go up nearly 26% or down almost 26% over the next year, the probability of the bond market going up 5.7% over the next year is remote. Why? Because interest rates are close to zero.

Think of it this way. The U.S. Treasury recently auctioned off 10-year Treasuries, with an interest rate of 0.625%. Investors were willing to pay 99.73 cents on the dollar to buy these instruments, which worked out to a yield of 0.61%.

Now, for Treasuries to go up 5.7%, that would require someone to be willing to pay 105.41 cents on the dollar (the sum of 99.73 x 1.057) for these same notes. At that yield, an investor would be tying up money for 10 years at almost no return (the yield works out to 0.08%). While we do see negative 10-year rates in Europe and Japan, you have to ask yourself how likely that is. For that to happen, you have to bet that the U.S. experiences strong deflation, and the Fed is pulling out all the stops trying to prevent that from happening.

On the other hand, how likely is it for the 10-year Treasury to drop by 5.7%? That would mean investors are willing to pay 94 cents on the dollar, and a 10-year bond paying 0.625% at 94 cents on the dollar works out to be a 1.3% yield, which is where we were in February. In other words, the interest rate risk in the bond market is asymmetrical, because interest rates are close to zero. The potential upside is limited, while the downside is not.

While corporate bonds have credit risk as well as interest rate risk, which means they have a higher yield, you have to ask yourself the same sort of question of upside versus downside. Below, you have a chart of investment-grade yields and "junk bond" yields. In both situations, you see the returns are relatively paltry. 

US Corporate AAA Effective Yield Chart

US Corporate AAA Effective Yield data by YCharts

In this situation, the question to ask is: How "conservative" are bonds right now, really? If the upside is limited, and the downside is much more severe, are you really doing yourself a favor by putting them in your portfolio? What would need to happen in the economy for this to be a good investment? If the answer is that the U.S. has to go into a deflationary spiral like Japan, ask yourself if that is as likely a situation as interest rates going back to February levels.

While the Fed has forecast that it intends to keep the Fed Funds rate at close to zero through 2023, that doesn't mean the 10-year bond can't fall. Investors who are considering the safety of bond market investments should understand that the bond market, or the iShares 20+ Treasury Bond ETF (NYSEMKT: TLH), is priced for perfection, and the upside is quite limited. The risk and reward calculation for the U.S. Treasury market is completely out of whack, and historical asset allocation rules of thumb (X minus your age = the percent of your portfolio that should be in stocks) need to be reconsidered to account for the current circumstances. 

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Brent Nyitray, CFA has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Cboe Global Markets Inc. The Motley Fool has a disclosure policy.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.


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