Article in Summary:
- Treasury bonds have been yielding 3.6 – 3.9% per year for the past month
- Investors are buying 30-year treasury bonds in record amounts
- There is a bond bubble brewing, and if it bursts, could be disastrous to your bond portfolio
For the past month or so, 30-year Treasury bonds have been yielding around 3.6-3.9% per year – a couple of percent more than shorter-term Treasury bonds. Investors hungry for yield in the current low-interest-rate environment are piling into 30-year Treasuries. Many of these investors figure the added interest is a risk-free return. After all, the government isn’t going to default on its bonds, is it?
Not so fast. I don’t think the government is going to default, but that’s not the only risk with long-term Treasury bonds. There’s also interest rate risk. Most investors don’t even know what interest rate risk is. Here’s how it works.
Suppose an investor buys a 30-year Treasury bond today. He pays $1,000 to the US Treasury, which promises to pay him interest twice a year, and then repays his $1,000 principal at the end of the bond term in 30 years. Simple.
But then, say the investor decides he wants to sell the bond he’s purchased. No problem; there’s an active market for long-term Treasury bonds. But the resale price of the bond will vary with interest rates; if rates rise, the resale price will fall. How much? Maybe a lot:
|30-year, $1,000 Treasury Bond, 3.6% interest|
|If interest rate
climbs by …
drops by …
drops to …
Lest you think interest rates can’t jump like this in the real world, interest rates actually did climb by 1.2% just last spring. Over time, a 3% increase in interest rates, or more, is hardly out of the question. Some readers will remember the 1970s, when interest rates went over 15%. (In that environment, a 30-year Treasury bond bought today would lose three-quarters of its value.)
What makes the long bond so risky is its 30-year term. The U.S. Treasury also sells short-term bonds (1-year maturity), and these are much less sensitive to interest rates. We recommend short-term Treasuries for people who want to protect their capital.
So even though there is little risk of default with long-term Treasury bonds, using them to chase a couple of extra percentage points is a risky pursuit. It’s a popular strategy right now, though. Some observers are even describing bonds’ current popularity a bubble. Warren Buffett, for example, said in his 2008 shareholders letter, “When the financial history of this decade is written, it will surely speak of the Internet bubble of the late 1990s and the housing bubble of the early 2000s. But the U.S. Treasury bond bubble of late 2008 may be regarded as almost equally extraordinary.”
Bubble or not, buyers of long-term Treasuries who don’t understand how their resale value changes with rising interest rates may have a rude shock down the road.