Investing in Bonds For Dummies. Russell Wild

to our present time, a $10,000 investment in the S&P 500 at the beginning of 2000 was worth only $5,800 after three years of a growly bear market. But during those same three years, long-term U.S. government bonds soared. A $10,000 70/30 (stock/bond) portfolio during those three years would have been worth $8,210 at the end. Another big difference.

      In 2008, as you’re well aware, stocks took a big nosedive. The S&P 500 tumbled 37 percent in that dismal calendar year. And long-term U.S. government bonds? Once again, our fixed-income friends came to the rescue, rising nearly 26 percent. In fact, nearly every investment imaginable, including all the traditional stock-market hedges, from real estate to commodities to foreign equities, fell hard that year. Treasury bonds, however, continued to stand tall.

      Clearly, long-term government bonds can, and often do, rise to the challenge during times of economic turmoil. Why are bad times often good for many bonds? Bonds have historically been a best friend to investors at those times when investors have most needed a friend. Given that bonds have saved numerous stock investors from impoverishment, bond investing in the past eight to nine decades may be seen not as a miserable failure but as a huge success.

Gleaning some important lessons

      Bonds have been a bulwark of portfolios throughout much of modern history, but that’s not to say that money – some serious money – hasn’t been lost. In this section, I offer examples of some bonds that haven’t fared well so you’re aware that even these relatively safe investment vehicles carry some risk.

       Corporate bonds

      Corporate bonds – generally considered the most risky kind of bonds – did not become popular in the United States until after the Civil War, when many railroads, experiencing a major building boom, had a sudden need for capital. During a depression in the early to mid 1890s, a good number of those railroads went bankrupt, taking many bondholders down with them. Estimates indicate that more than one out of every three dollars invested in the U.S. bond market was lost. Thank goodness we haven’t seen anything like that since (although during the Great Depression of the 1930s, plenty of companies of all sorts went under, and many corporate bondholders again took it on the chin).

      In more recent years, the global bond default rate has been less than 1 percent a year. Still, that equates to several dozen companies a year. In recent years, a number of airlines (Delta, Northwest), energy companies (Enron), and one auto parts company (Delphi) defaulted on their bonds. Both General Motors and Ford, as well as RadioShack experienced big downgrades (from investment-grade to speculative-grade, terms I explain in Chapter 2), costing bondholders (especially those who needed to cash out holdings) many millions.

      Lehman Brothers, the fourth largest investment bank in the United States, went belly up in the financial crisis of 2008. Billions were lost by those in possession of Lehman Brothers bonds. (Many more billions were also lost in mortgage-backed securities and collateralized debt obligations. These investments are debt instruments issued by financial corporations, but they are very different animals than typical corporate bonds and rarely spoken of in the same breath. I’ll get to those in Chapter 5.) Most recently, we’ve witnessed the collapse of once very healthy corporations, from Borders to Sharper Image to Kodak. Even Hostess became little more than crumbs. (It’s tough to imagine that with our insatiable appetite for sugary snacks, a company could lose money on Ding Dongs and Twinkies!) As we’ve seen time and time again, corporations sometimes go under. None are too big to fail.

       Municipal bonds

      Municipal bonds, although much safer overall than typical corporate bonds, have also seen a few defaults. In 1978, Cleveland became the first major U.S. city to default on its bonds since the Great Depression. Three years prior, New York City likely would have defaulted on its bonds had the federal government not come to the rescue.

      The largest default in the history of the municipal bond market occurred in 2013, when Detroit declared bankruptcy, leaving holders of more than $8 billion in bonds wondering (and, at the time of this writing, they are wondering still) if they will ever their money back.

      Largely due to the situation in Detroit, there has been lots of talk about municipal bankruptcies of late. Yet not many have occurred. In recent years, the number of municipalities defaulting on their bonds has been estimated to run about 6/10 of one percent.

      Several budget-challenged cities and counties have had to make the difficult choice between paying off bondholders or making good on pension obligations for retired police, firefighters, and teachers. Thus far, the retired workers have suffered more financial pain than the bondholders, perhaps because they have less political clout – and no one wants to alienate bondholders, who may provide much-needed cash in the future.

       Sovereign bonds

      Nations worldwide also issue government bonds. These are often called sovereign bonds. The largest default of all time occurred in 1917 as revolutionaries in Russia were attempting to free the people by breaking the bonds, so to speak, of imperialist oppression. Bonds were broken, for sure; with the collapse of the czarist regime, billions and billions of rubles-worth of Russian bonds were suddenly worth less than non-alcoholic vodka. Most had been sold to Western Europeans. In France, the Parisian government urged people to reject the new Bolshevik regime and show their support of the monarch in Moscow by purchasing Russian bonds. About half of all French households held at least some Russian debt.