There's been a debate brewing in the markets about whether the treasury bond market is reaching valuations approaching a bubble, which could pop and create significant losses for investors. I believe treasury bonds are extremely overpriced, and that investors need to tread carefully in what's typically considered a "safe" investment. If you're not careful with the duration or maturity (how long before an issuer is required to pay back your principal) of treasury bonds you buy, you could end up losing money in them as interest rates climb.
Investors have been piling into bonds since the beginning of 2009. According to the Investment Company Institute, investors have added more than $215 billion to bond funds since the first of the year through the end of August—adding money at a time when interest rates are at historic lows.
To me, it looks like investors are engaging in the same behavior they did during the dot-com frenzy and the housing bubble—they're buying what has been hot in the recent past, instead of looking for what will be the best investment down the road. It's sort of like horse racing. Bettors at the track study a horse's handicap to guess whether it will win the race. But just because a horse has won in the past doesn't mean the horse will finish first in the next race.
[For an alternative to bonds, see When Investors Fail, This Is a Reason Why . . .]
The heavy demand for bond funds, along with the large purchases of treasury bonds by the Federal Reserve, has pushed prices higher and sent yields to historic lows. But that trend will eventually change. In September, treasury prices started to creep lower, pushing yields up. On September 30, the benchmark 10-year Treasury note yielded 2.517 percent, up from 2.472 percent at the end of August and the year's lowest level of 2.418 percent on August 25.
When the economy finally starts to show some more zest, the Federal Reserve will likely shift its current zero interest rate policy and lift rates. That means treasury prices will fall even further. And professional investors will likely sell bonds in anticipation of Fed actions, meaning that rates will actually go up before there is any sort of announcement for the retail investor to use as a signal of rising rates.
For this reason, we recommend that investors stay away from longer maturity treasury bonds and stick to bonds with maturities of five years or less. Here's why: if you own a bond with a five-year maturity and rates go up 1 percent in one year, the bond will lose just 0.5 percent of its value. In the same scenario, the value of a 10-year maturity bond would fall 4 percent, while a 30-year bond would lose 12 percent.
When rates go up, it will be just as important to make sure you will get the return of your investment as it is to get a return on your investment. There are times when it pays to be defensive—even in bonds.
I understand that many investors will keep scrambling for any investment with a higher yield when interest rates are drastically low. Even though shorter-term bonds offer a lower interest rate, you'll lose less value over time than if you own a longer-term bond when interest rates rise. Another way you can lose money in bonds is if you're required to sell the bond prior to maturity. And if you hold a bond until maturity, you could miss better investment opportunities.
Just remember that when interest rates rise, you actually can lose value in treasury bonds.
Adam Bold is the founder of The Mutual Fund Store, which provides fee-only investment advice with locations coast-to-coast. He's also host of The Mutual Fund Show, a call-in radio program broadcast across the country. Bold is author of the book The Bold Truth about Investing (April, 2009). Bold is Chief Investment Officer of The Mutual Fund Research Center, an SEC registered investment adviser which provides mutual fund and asset allocation recommendations and research to stores in The Mutual Fund Store system.