Can Long Term Bonds Be a Value Trap?

Investors who are seeking decent yields are being lured with the siren song of long term bonds.  True, you may be able to get a little higher yield on the longer term, but is it worth the risk? 

As of the day I am writing this, the one-year Treasury sits at 0.56%, five years are at 1.17%, and thirty-year T Bonds are at 2.47%.  So the thirty year is 1.91% over the one year and is 1.30% over the five year.  While these longer term debt notes have a higher yield, in the current market conditions they may cause a value trap that will bring losses in the long run.  As an income source, there is a lot of risk and not much upside.

Sovereign debt is dominated in that nation’s currency could be a one-way bet against the investor.   At one time, when the monetary system was tied to hard assets like gold, long term bonds were a great option.  The investor would receive a fixed stream of payments over time and a return of principal at the end.  Prices could move up or down during the bond term but since money was tied to gold, investors had no reason to expect severe movements.  The retiree could rely on these to fund their retirement. 

This all changed when the U.S. went off the gold standard in 1933.  Once bonds were liked to paper currency, governments were tempted to inflate their currency, thus reducing their debt.  Franklin Roosevelt invalidated gold clauses in that year and at the same time he raised the price of gold from $20.71/ounce to $35/ounce.  US Government debt holders who were to be paid in gold, were repaid in devalued dollars. 

Now with the value of money and the money supply being controlled by the government, long-term bondholders have the deck stacked against them.  The government can be fiscally irresponsible, run high deficits, providing goods and services without paying for them and then finance the increase by allowing inflation.   The government can benefit by paying back the debt with inflated dollars, if the government decides to pay back the debt at all. 

Investors who bought 30-year bonds at 5% in the 1960s believed there was some allowance for inflation built in, saw their principal decline by 75% over the life of the bond.  At some point, investors will get sick of seeing their savings wiped out with the inflation.  As the issue becomes critical, the government will step in to reverse the price increases. 

This is what Paul Vockler did in the 1980s when inflation was lowered from 14% to 4% in a matter of a few years.  Now a bondholder who purchased a 12% long term bond in the early 1980s would have seen a huge increase in their principal value as the yields in the market eroded down to the levels we have today. 

Double digit inflation can cause a lot of damage to the economy.  If inflation ever reached that point, the government would aggressively step in to rein it in.  But even at lower levels of inflation, there is a level of interest payment that make long-term bonds a challenged investment.  The current rate of inflation over the past year is 1%.  If, as an investor, you desire a rate of 3%, then factor in inflation, and add another percent for any uncertainty, gives one a rate of 5%.

Yet the 30-year Treasury sits at less than half of that at 2.47%.  This is 49.4% of par value at 5%.  So the market yield on the bond is less than half of what you should earn.  But with holding a US bond until 2046 is not attractive at the current rates.  A long term hold strategy will also erode your principal on the bonds.  You probably will not want to hold the bond for a long term with the small yield you are making over the inflation rate.  There is still some possibility of an increase in the principal value of the bond if rates are pushed down further.  But the Fed is watching other countries like Japan, Switzerland, and Denmark, and sees that negative rates do not provide the stimulus desired for your economy. 

The bottom line is that in these markets it is hard to get a decent return without taking a little more risk.  There is also a risk in buying and holding US Treasuries at such as low interest rate.  If you desire safety, it may be more reasonable to look at t shorter maturity of security.