Think bonds are safe?
Most people would agree that bonds are one of the safer investments and a great alternative to the stock market for the risk-adverse. If you’re older or more conservative or can’t handle the ups and downs of a good mutual fund, bonds are where your money should go.
Or are they?
The idea that bonds are safer than stocks is true in one sense and untrue in another.
What Are Bonds?
Bonds are loans. Unlike stock where you’re paying for part ownership, bonds are low-interest loans given to a company, organization, or country.
Like car or home loans they are broken up into years and can be paid out yearly, quarterly, or once at the end of the loan term.
So when someone says, “China owns America” what they mean is China owns a massive amount of U.S. bonds. To put it another way, China has loaned America a huge amount of money and now we owe insanely more than we make in taxes and fees.
The Risk of Bonds
So what’s the risk of bonds? Most people would say “none”. But there is one huge risk: bankruptcy.
Bonds are considered safer than stocks because a company has to pay bond holders before stock holders if they file bankruptcy.
But what if the company doesn’t have the assets to pay bond holders? It’s like you or I filing bankruptcy on a credit card. Sure, we might pay part of the loan, but most of it disappears.
It’s hard to explain without examples, so I’ll give you two: Enron and Greece.
Remember Enron? Before the scandal, Enron was the sure thing. If you had a mutual fund, they were in it. If you were looking to trade bonds, they were the ones you wanted. They were profitable and growing bigger every day
Or were they? Underneath the hype, Enron was a lie.
They were using shelter corporation and shady (but legal) accounting practices to turn billions of dollars in losses into profits.
The insane profits are what made everyone want to give them money — until 2001.
In 2001 they filed for bankruptcy protection and after years of proceedings (and lots of jail time for executives) they liquidated. Stock holders lost everything; millions of lives were ruined; and even the bond holders were left with nothing but a piece of paper.
Greece is a bit more recent.
Most Americans don’t really know what’s going on in Europe outside of a “debt crisis” (whatever that means). A few know that Greece is somehow involved.
The Greek Debt Crisis started with a lie.
The country was able to adopt the Euro as its currency because it lied about its high deficit levels. Because of the lies, investors put money into Greek bonds. When the truth came out and Greece had to announced their true deficit levels, bond holders cut their losses and ran.
In an instant, Greece ran out of money and their already shaky economy crumbled.
Currently, Greece hovers on the edge of bankruptcy with only a German bailout to possibly save the day. Unfortunately for bond holders, bailouts are never free. As part of the bailout terms, Germany and other European nations are requiring Greece to nullify several of its debts.
To put it another way, Greece isn’t going to pay the people, organizations, and countries who loaned the money; and there is nothing we can do about it.
The Greek bond holders will are left with little to nothing, even though Greek bonds were a “sure thing” only a few years ago.
Should I Get Rid of My Bonds?
Bonds aren’t bad, and in a lot of instances they can be really good – but they are never safe.
Any organization, corporation, or country can crumble. Anyone you accepts a loan can run out of money to pay it back.
But that’s part of investing. There is no such thing as a safe investment; else there would be no profits.
Having bonds as part of a solid mutual fund and talking them through with an investment professional is necessary for any investor. They’re a great buffer against a falling stock market.
Just don’t think of them as safe.
Do you invest in bonds?