Bonds Are a 'Safe' Investment: A Big Lie Gets Even Bigger

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bondsIt's happening again.

About a month ago, bemused investors awoke to news that over in Germany, the government had just sold $5 billion worth of Eurobonds that paid an average interest rate of -- get this -- negative 0.0122%.

In other words, if you bought one of these bonds for 100.01 euros, in six months you return it to the government and get back 100 euros.

While we've seen this happen in other "safe haven" countries -- Switzerland and the Netherlands -- this was the first time it had happened in Germany. For many bond investors, it won't be the last.

The Trouble with Europe (but Not Only Europe)

Here's the problem. In the bond secondary market (fancy industry-speak for people reselling bonds that the government has already issued), some bonds backed by governments deemed unlikely to go bankrupt have traded at negative yields on several occasions in recent months. Yields on already-issued three-month U.S. Treasury bonds were briefly negative back in October.

In early February, Barron's reported that the U.S. Treasury is pondering the next logical step: selling bonds that pay negative interest from the get-go. And why shouldn't they? When similar bonds are already changing hands at negative yield on the secondary market, it's clear that people are willing to accept negative interest for the perceived safety of investing in T-bills.

Why should government "leave money on the table?" If bond buyers will pay up for the privilege of owning a U.S. bond, maybe Washington could get a taste of this free-money action, too?

Gimme All Your Money. Now ... Pay Me to Take It

But isn't this, well, crazy? I mean, if Uncle Sam can convince people to lend him money, and to pay for the privilege -- good for him. And three cheers for the good ol' U.S. of A. If investors are so sure we will repay our debts that they'll accept a small loss on their investment for the surety they'll get most of their money back, we must be doing something right.

But is investing in Treasury bonds the right decision for individual investors? Probably not.

Why You Should Put Bond Buying on the Back Burner

Given a choice between buying "risky" stocks and "safe" bonds, bonds naturally attract investors who are reluctant to "gamble" with their savings. That thinking can get you into hot water.

• Rising risks: As thousands (millions?) of folks who bought Greek government bonds learned last year, bonds aren't really risk-free after all. The further in debt a government gets, the higher the odds that it won't repay its debts. And the higher the odds a government won't pay its debts, the less valuable its bonds become.

In Greece's case, the government is trying to hammer out a deal that would involve at least a 50% writedown in bond values, and there's no law that says it couldn't happen here, too. Greece got in trouble because it allowed its government debt to rise to 160% of GDP. America, which had a debt-to-GDP ratio of less than 60% as recently as 2000, recently topped 100%. In short: We're not standing in Greece's galoshes just yet, but we're close.

• Rising inflation: Rising inflation can steadily eat away at the value of investors' bond holdings. Consider that if a bond you buy pays negative interest, or zero interest -- or even 1%, 2%, or 3% -- there's a good chance that rising inflation will eat up any profits the interest might have earned you, leaving you with a loss.

Sure, some investors dodge this risk by buying "Treasury Inflation-Protected Securities," bonds whose value rises automatically to match the inflation rate. The catch: Many TIPS are already trading for negative real interest rates. (You just can't win.)

With Rates Like This, Who Needs Risk?

My No. 1 objection to buying bonds, though, is the obvious one. Default may or may not happen. Inflation may or may not be severe. If it was just these risks to worry about, I can understand why someone might gamble on a bond bet. But why in heaven's name would anyone make a deal that guarantees they lose money?

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Because that's exactly what you're doing when you buy a bond paying a negative interest rate. No ambiguity.

Okay, yes. If you're a big company like Apple, with tens of billions in cash that you need to stash somewhere, you may prefer the relative safety and liquidity of bonds -- even ones paying negative interest -- to the risk of putting your cash in a bank that could go belly-up, with no FDIC insurance to save you. And mutual funds and pension funds may be required by their corporate charters to keep their money in short-term bonds.

For the rest of us, rather than buy bonds, the smarter move is to put your money in dividend-paying stocks like Intel (INTC) or Microsoft (MSFT) or any number of the stalwart blue chips that, unlike the Treasury, pay real money in the form of dividends (2.7% for Microsoft, 3.2% for Intel). There's another way such stocks are unlike the U.S. government: They're not mired in debt, but flush with cash. I'll take these kinds of "risky" investments any day of the week.

Motley Fool contributor Rich Smith does not own shares of any company mentioned above. The Motley Fool owns shares of Microsoft and Intel. Motley Fool newsletter services have recommended buying shares of Intel and Microsoft, as well as creating a bull call spread position in Microsoft.
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