Bonds Are Riskier Than Ever. Here's Why.

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In investing, bonds have always had a reputation for being the safe choice. Compared to the wild oscillations one can get in the stock market, bonds appear stable and downright boring: They make predictable interest payments and eventually return the invested principal to their buyers at maturity.

Lately, though, some troubling trends have turned against bond investors. In particular, two recent events have shown just how willing the government entities that issue bonds are to put investors at risk of losing their investments.

The Debt Ceiling And You

The government shutdown in Washington has affected millions of Americans, with an estimated 800,000 federal workers having been furloughed, and many private businesses and their employees suffering from the collateral damage of shutdowns of government agencies and of federally-owned landmarks like national parks.

But of greater importance to investors around the world is the debt ceiling debate.

Under current law, the government sets a limit on the total amount of debt that it is allowed to incur. At the current rate of borrowing, the national debt will hit that limit later this month.

Until recent years, most investing analysts assumed -- correctly -- that lawmakers would raise the debt ceiling as necessary without much fuss. Now, though, there's a very real possibility that Congress won't take action, which could cause the U.S. to default on some of its debt.

Investors have reacted to that possibility. Rates on the shortest-term Treasury bills available have jumped eightfold in just the past week as those who invest in that short-term debt have to factor in the risk that they might not be repaid on time when their Treasury bills mature next month.

%VIRTUAL-article-sponsoredlinks%Moreover, foreign bondholders aren't happy with Congress's shenanigans over the debt situation. Chinese officials noted recently that they wanted the U.S. government to protect the safety of its bond holdings in light of the debt-ceiling deadline. Similarly, Japan, which is the second-largest foreign bondholder of U.S. Treasuries behind China, wants reassurance that a U.S. debt crisis won't jeopardize its strategy of weakening the Japanese yen against the dollar.

Regardless, members of Congress haven't seemed deterred by the potential impact of a bond default on investors. Despite tens of millions of Americans having a stake in Treasury debt either directly through their investments or indirectly because of the Treasury holdings that entities like pension funds own, their elected representatives aren't rushing to resolve the debt ceiling issue.

Striking a Balance

Indeed, governments seem more willing than ever to let bondholders shoulder a share of the burdens created by our still-shaky economy.

At the local level, the bankrupt city of Stockton, Calif., issued its plan to exit legal bankruptcy proceeds late last month. The plan included forcing bond investors to accept a substantial reduction in the amount of interest they would receive on their bonds, as the city has said that it can pay less than 20 percent of the $2.9 million in annual bond-financing costs.

Bondholders won't be the only ones hurt by that bankruptcy.

Stockton also intends to raise sales taxes in the city and has already reduced services and made employee cuts before the bankruptcy was filed. The plan does preserve pension payments to retirees, although retired workers will lose health-insurance subsidies they previously received.

Bond investors do have the right to fight the plan in bankruptcy court, arguing that they're being treated unfairly. Increasingly, though, the concept of "fairness" that bankrupt cities and towns espouse includes having bondholders suffer losses. That's contrary to past experience, in which bond investors could expect repayment in full before other stakeholders got any recovery.

Bonds: Know the Risks

If you thought bonds were risk-free, recent events should have you rethinking that assessment. Before you add bonds to your portfolio, make sure you understand the real and growing possibility that you might not get repaid in full or on time.

Even if the debt-ceiling debate gets resolved favorably this time around, the trend toward less protection for bond investors could nevertheless continue in the future.

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Bonds Are Riskier Than Ever. Here's Why.

Warren Buffett is a great investor, but what makes him rich is that he's been a great investor for two thirds of a century. Of his current $60 billion net worth, $59.7 billion was added after his 50th birthday, and $57 billion came after his 60th. If Buffett started saving in his 30s and retired in his 60s, you would have never heard of him. His secret is time.

Most people don't start saving in meaningful amounts until a decade or two before retirement, which severely limits the power of compounding. That's unfortunate, and there's no way to fix it retroactively. It's a good reminder of how important it is to teach young people to start saving as soon as possible.

Future market returns will equal the dividend yield + earnings growth +/- change in the earnings multiple (valuations). That's really all there is to it.

The dividend yield we know: It's currently 2%. A reasonable guess of future earnings growth is 5% a year. What about the change in earnings multiples? That's totally unknowable.

Earnings multiples reflect people's feelings about the future. And there's just no way to know what people are going to think about the future in the future. How could you?

If someone said, "I think most people will be in a 10% better mood in the year 2023," we'd call them delusional. When someone does the same thing by projecting 10-year market returns, we call them analysts.

Someone who bought a low-cost S&P 500 index fund in 2003 earned a 97% return by the end of 2012. That's great! And they didn't need to know a thing about portfolio management, technical analysis, or suffer through a single segment of "The Lighting Round."

Meanwhile, the average equity market neutral fancy-pants hedge fund lost 4.7% of its value over the same period, according to data from Dow Jones Credit Suisse Hedge Fund Indices. The average long-short equity hedge fund produced a 96% total return -- still short of an index fund.

Investing is not like a computer: Simple and basic can be more powerful than complex and cutting-edge. And it's not like golf: The spectators have a pretty good chance of humbling the pros.

Most investors understand that stocks produce superior long-term returns, but at the cost of higher volatility. Yet every time -- every single time -- there's even a hint of volatility, the same cry is heard from the investing public: "What is going on?!"

Nine times out of ten, the correct answer is the same: Nothing is going on. This is just what stocks do.

Since 1900 the S&P 500 (^GSPC) has returned about 6% per year, but the average difference between any year's highest close and lowest close is 23%. Remember this the next time someone tries to explain why the market is up or down by a few percentage points. They are basically trying to explain why summer came after spring.

Someone once asked J.P. Morgan what the market will do. "It will fluctuate," he allegedly said. Truer words have never been spoken.

The vast majority of financial products are sold by people whose only interest in your wealth is the amount of fees they can sucker you out of.

You need no experience, credentials, or even common sense to be a financial pundit. Sadly, the louder and more bombastic a pundit is, the more attention he'll receive, even though it makes him more likely to be wrong.

This is perhaps the most important theory in finance. Until it is understood you stand a high chance of being bamboozled and misled at every corner.

"Everything else is cream cheese."
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You can follow Motley Fool contributor Dan Caplinger on Twitter @DanCaplinger or on Google+.
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