Bond Market Crash: Is Disaster Ahead for the 'Safe' Part of Your Portfolio?

Bond market crash
Bond market crash

Just when you've finally gotten over the stock market crash from four years ago, there's a new threat that could potentially hit your portfolio. Even worse, it's in an area that many people think of as being safer than stocks: the bond market.

Goldman Sachs (GS) is the latest big Wall Street institution to sound the alarm about a potential bond market crash. Although bond-market dynamics are sophisticated and complex, the argument against bonds boils down to these simple points:

  • Interest rates are near all-time lows, which means that the prices of bonds and bond funds, which go the opposite direction of rates, are extremely high right now.

  • Nevertheless, investors have piled into bond investments over the past several years, accepting lousy guaranteed returns in exchange for the near-certainty that they won't lose any principal.

  • Corporations and other borrowers have been issuing huge amounts of bonds into the market, raising cash and refinancing their debt to take advantage of low rates before the opportunity to get cheap financing disappears.

  • In the past month, rates have started ticking upward, and further rate rises -- which many see as inevitable -- would send bond fund prices down.

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Even worse, many investors who've been trying to boost the income from their portfolios have unknowingly increased their risk in a potential bond market crash. Just as a five-year CD pays more than a one-year CD, longer-dated bonds have better rates. But their prices are also more vulnerable to interest-rate increases, magnifying their future losses if rates rise sharply. Brokerage firm UBS (UBS) even plans to take the extraordinary step of classifying bond investors as "aggressive" because of the firm's negative outlook for the bond market.

Where Can You Take Cover

Goldman and other Wall Street firms can use expert strategies and complex financial products like derivatives to give them protection against rising rates and falling bond prices. For regular investors, though, the options are more limited.

Here are some ways you can take cover if you agree that a bond-market crash is coming:

  • Think short-term. Investing in short-dated bonds reduces the interest rate you get now, but if rates rise, you don't have to wait as long before you get to reinvest in a new bond paying a higher rate. Bond funds that own short-term bonds also don't lose value in rising-rate environments as much as longer-term bond funds.

  • Look at CDs instead of bonds and funds. Bonds and bond funds can rise and fall in price, but with CDs, you always have the option of withdrawing your money simply by paying an early-withdrawal penalty. With some banks letting you take money out by paying as little as three months of interest, if rates rise dramatically, you can grab your CD money early and reinvest it in a higher-paying CD.

  • Consider inflation-protected savings bonds. One of the best deals in the market right now is the Series I savings bond, which pays returns based on the current rate of inflation. The rate changes automatically every six months, but you don't have to pay taxes on the interest until you cash them in. One caveat: you can't cash them in for a year, and if you hold them less than five years, you'll pay a three-month penalty. (By the way, don't confuse these with TIPS -- Treasury Inflation-Protected Securities. Series I bonds are similar, but not the same.)

  • Beware of high-risk bonds. The safest bonds tend to pay the lowest rates, with Treasuries at the highest level of safety and corporate bonds offering successively higher interest rates as credit quality weakens. Many investors have gravitated to speculative high-yielding "junk" bonds because they pay 6 percent or more compared to less than 2 percent for comparable Treasuries. But if those somewhat riskier companies default on their debt, you could lose much or all of your investment.

Experts have been calling for a bond-market crash for many years, and so far, their cries have fallen on deaf ears. With more signs pointing to a healthier economy, though, rising rates look like they're getting closer. Take these simple steps and you'll reduce your losses if a bond-market crash happens.

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You can follow Motley Fool contributor Dan Caplinger on Twitter @DanCaplinger. Motley Fool newsletter services have recommended Goldman Sachs.

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