The Ignorant Investor

There are times when brevity is favored in our culture. Not just in line at the movie theater, where you're not supposed to chat with the ticket clerk other than to say, "Two for 'Star Wars' . . . thank you." Or when you go to the doctor complaining of an ache in your wrist and she looks it over and says, "It's probably nothing- come back in two weeks if it still hurts" before moving onto the next patient on her list. Or when you get fired from your job and you come back to the building the next day with a handgun, and everyone is like "Omigod- don't kill me...." and you're like, "Duh- I'm not here to kill anyone, I'm just waving around the gun because I want the police to shoot me because I've got no job . . ." and then they all run away like you've said something really weird and they won't spare you the time of day. That's the culture we live in, I guess. Nobody has the time to share a moment any more.

So in talking about bonds I'll make this quick. In my last post I discussed the benefits of owning bonds. Besides earning interest, if interest rates fall the value of existing bonds goes up because the old bonds earn more interest than the new ones (seems reasonable, right?). In times of falling rates, a bond fund manager can sell some of the high-earning bonds in his portfolio and pick up a nice fat wad of capital gains for his clients, and we likes our capitals gains.

But what happens when interest rates rise? Well, the opposite happens. The old bonds now earn less than the new ones, which makes them less valuable to any buyer. As bond prices fall, capital losses can wipe out a years worth of interest payments. In Vanguard's long-term bond index fund, for example, this happened twice: once in 1996, and again in 1999. So long-term bonds are not completely insulated from either losses or volatility.

It's a different story with short-term bond funds. The bonds they hold expire at a much faster rate, freeing up cash to be re-invested in new bonds at the now higher rates. It's not impossible to get tagged with capital losses in a short-term fund, but the magnitude of capital losses in any given year aren't likely to wipe out most of a year's interest payments.

Now to the future. The past ten years have been good to bond investors as interest rates slowly climbed down from their highs of the 1980s and early 90s. Absent some kind of severe deflationary spiral into a depression, we're not likely to see them go much lower. Add to that the risk that we may be entering a period of higher inflation, and the magic eight ball says all signs point towards at least minimally higher rates. According to conventional wisdom, the only thing holding long term rate down now is the desire of Asian bankers to lend the U.S. treasury massive amounts of cash. It is axiomatic in America that Asians are inscrutable, so nobody here can really know when this lending may stop. When it does, rates will start to climb. Or so I'm told. Keep in mind, I'm the ignorant investor. Economics is not my bag, baby.

Short form: Long term bond funds typically offer higher returns in the long run, particularly because they offer greater capital gains than short term bond funds. But in investing bigger gains usually require taking on greater risk. Short-term funds offer less risk of capital loss in the near term, but there's a chance that interest payments will lag the rate of inflation over extended periods. Basically, if you don't need the money any time soon, conventional wisdom points towards long-term bonds despite the increased volatility. I agree. Maybe.