Ultra-low interest rates are making bonds unsafeJune 7, 2013: 7:22 AM ET
Sooner or later, interest rates are going to rise sharply from current levels. And that'll hurt.
FORTUNE -- What do you call a supposedly safe investment in which a five-week hiccup can wipe out more than a year of income? Answer: a bond mutual fund.
Yes, that sounds extreme, if not demented. But it's true—as I'll show you in a bit, using numbers from the nation's biggest mutual fund, Pimco Total Return, which is run by bond-dom's most prominent investor, Bill Gross.
If you're a typical investor—especially, if you're a typical investor of my age (68)—you've heard for decades about bonds providing a safe haven. But as people like my Fortune colleague Shawn Tully and I have been warning you for quite awhile now, buying bonds at today's ultra-low interest rates isn't at all safe.
Look at the Pimco fund. From the start of May through Thursday's market close, the net asset value of Pimco Total Return Class A (PTTAX, for those of you keeping score at home) dropped to $11.05 from $11.34. Reason: the relatively modest increases in interest rates since the end of April have decreased the value of the fund's $290 billion or so worth of bonds. Gross has been a terrific money investor for decades, and I think very highly of him. But he—like all bond fund managers—is swimming against the tide these days.
The 29-cent price drop in Gross' fund may not sound like all that much. However, it's more than all the interest dividends that Pimco holders got for the 12 months ended May 31—although you won't realize this unless you dig quite deeply into the fund's numbers.
According to data that I got from Morningstar, investors got 28.082 cents of interest dividends for the year ended May 31: less than the aforementioned 29-cent decline.
This loss is masked by the fact that during the 12 months we're discussing, PTTAX paid holders 26.9 cents of capital gains dividends, and a "special cash distribution," required by obscure portions of the tax code, of 11.4 cents. Subtract these two items from the fund's total 12-month distributions, and you're down to 28 cents.
Why the price loss? Because, as they teach you in Bonds 101, when interest rates rise, the prices of existing bonds fall.
Say that on Apr. 30, you paid face value for a 10-year Treasury note yielding 1.70%, the then-prevailing rate. These days, the yield on 10-year Treasurys is 2.10%. This seemingly small increase—what's four-tenths of a point between friends?—resulted in a decline of more than 3.5% in your note's market value. That drop—$356, according to the bond calculator I'm using—is more than two years of your $170-a-year interest proceeds.
You can take your loss all at once by selling your Treasury note for $9,644, or take it a piece at a time by collecting $170 of annual interest for the next 9 years and 11 months while investors buying at today's yield are collecting $210.
But if you own an individual security, you at least have the option of holding onto it until it matures, when you get your money back (unless the issuer defaults).
By contrast, bond funds never mature. There's no way to tell when—if ever—they will be worth what they fetched five weeks ago.
I'm not sure—and no one is—if this recent interest uptick is just a blip, or whether it signals the advent of years of higher rates. The Federal Reserve, which has gone to extraordinary lengths to hold down rates in the name of economic stimulus, may be getting overpowered by the power of the world's financial markets. Then again, we could be seeing a market overreaction, and rates could start heading down tomorrow. I don't know what the near future holds, no one does.
But one thing I do know is that sooner or later, interest rates are going to rise sharply from current levels, and stay higher indefinitely. When that happens, it will make the pain being sustained by bond investors today seem as gentle as a mother's kiss.