US Credit Rating Questioned: Bonds Investors Face Trap

December 21, 2012, 08:39 am ET, BY Thomas H. Kee Jr- Editor, Stock Traders Daily| Editor: Thomas H. Kee Jr. (Follow on LinkedIn)

In the early part of December a good friend of mine came to me and said he followed my advice.  He said that he saw risks in the economy, he recognized that the market was near the peaks that were set in 2007 and in 2000, and he also noticed that substantial declines happened after each one of those peaks, so he moved his 401(k) out of equity funds.  Just a week before I told him to move to cash, but when he called his 401(k) company they told him that the safest investment he could make was in a conservative bond fund.  They showed him the returns, the dividend, and the chart; he liked what he saw and thought it was conservative and safe, so he invested his money into the PIMCO total return bond fund. Although he did this within his 401(k) plan we can track it using the PIMCO total return bond fund ETF (NASDAQ:BOND), and the subsequent price movements are eye-opening.

When I heard what he did I snarled. "I never told you to invest in a bond fund" I said.  Unfortunately, as is the case with most 401(k) plans, the people that run his 401(k) want to keep him invested in some sort of mutual fund, whether it is a bond fund or an equity fund, so they steered him away from the money market account.  I have even heard cases where 401(k) plans do not offer cash accounts at all; the only reason I can imagine is that they don't earn fees if your money is in cash.  This goes for traditional money managers as well, investment advisors and stockbrokers of course, because in order for them to make money you need to invest in something.  These entities have a tendency to tell you to invest more all the time, no matter what, because the more you invest the more they make.  It makes good business sense for them, but staying invested at all times may not make good business sense for you.

In this particular case he noted the returns cited from his 401(k) plan administrators, the PIMCO total return bond fund did nothing but go straight up they said and he was somehow convinced that it would not lose value.  "They invest in bonds and bonds are conservative" he told me after I snarled at him. My response was a detailed explanation of how bonds and bond funds differ.  Investors who invest in individual bonds are guaranteed to get their principle back if they invest in insured bonds or US treasury bonds (I will talk more about UST Bonds below), but investors and bond funds are not guaranteed their principle at all.  There is a major difference between bonds and bond funds and the underlying premise is that bond funds do not guarantee your principal even if they invest in insured bonds themselves.

Unfortunately he did not heed my words and almost like clockwork US treasury bonds started to decline in value.  Interest rates have recently began to spike and although we can expect interest rates to fluctuate the inverse relationship between prices and interest rates has caused his otherwise safe bond fund to decline by about 1.5%.  This may not seem like a significant amount to an equity investor but when you invest in bonds for the purpose of securing your capital seeing a decline like this makes you very concerned.  Unwitting investors might not understand why a ‘safe’ instrument could lose value, it is directly related to the inverse relationship between price and interest rates, but something else happens when declines like this occur.

When investors select what seemed to be safe instruments like what is described above and those instruments decline slightly in value those investors often decide to just wait it out.  This creates a trap, and in this particular instance I call it a bond trap, where individual investors refuse to liquidate their bond funds because they believe for some obtuse reason that their bond funds will return their principle.  There is no insurance on bond funds and bond funds are not guaranteed to return principal.

When investors fall into this trap their monies become tied up in instruments that might actually begin to decline in value.  Imagine what would happen if US treasury bonds came out the favor and interest rates spiked even more than they have already.  Over the past year the PIMCO total return bond fund has increased as much as 10%, it is less than that now, but that was largely due to the decline in interest rates.  If interest rates change direction and over the course of the next year increase as much as they declined in 2012 this otherwise conservative bond fund, and others like it, could lose 10%, the opposite of what happened in 2012.

Investors in US treasury bonds have a degree of security, but even that may come into question soon.  If the federal government does not reach an agreement on the Fiscal Cliff Fitch will almost surely cut the US credit rating below AAA (almost immediately), and although Moody's will not likely do it immediately they will also have their finger on the trigger.  If the US loses its AAA rating from all agencies it will change the level of interest rates in the bond market and throughout the economy (more on this next time).

After careful review, no immediate trading signals exist yet according to our real-time reports for either the long-term US treasury ETF (NYSE:TLT) or its inverse, the short ETF (NYSE:TBT), but trading signals may soon come.  Although trading opportunities in these may come these opportunities do not translate into longer term investment opportunities in the bond market either.  There is as much of a difference between trading the bond market versus investing in it as there is investing in cash versus a bond fund. 

For investors interested in safety there is no better place than in cash.  Bonds are not the place to be, if you want to own them own individual bonds not bond funds, but I believe that given the low level of interest rates today that bond funds are just as risky, if not more risky because of their perceived safety, than equity-based investments in mutual funds.

For astute investors I continue to recommend proactive trading strategies that can make money if the market increases or if it declines, these are available to people who have money outside of 401(k) plans, but unfortunately the restrictions in many 401(k) plans only allow investment in mutual funds that exist within fund families, and those large mutual funds are not nimble enough to use proactive strategies like we are.  There is a competitive advantage for smaller investors, but that starts with not making simple mistakes.  If you want safety, bond funds are not an option.

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