The Risks of Debt Investing (1)

WALL STREET SMARTS, THE BLOG, IS NOW WALL STREET SMARTS, THE BOOK.  FULLY EDITED AND REVISED WITH NEW MATERIAL ON AMAZON

Ben Franklin may have said it best in 1758 when he wrote in Poor Richard's Almanack, "Creditors have better memories than debtors."  Sometimes, debtors just can't pay their creditors back.  Individual debt investors face the same issue as global banks.  How likely is repayment?  This may be their primary concern, but there are other issues, not as obvious, but just as important for individuals.

US Treasuries are considered the gold standard of debt.  America has always repaid its loans.  It is assumed by most that it always will.  When financial markets in the world get rough, US Treasuries are seen as a "safe haven" by both individual and professional debt investors.  Since repayment is not an issue, what other perils exist?  Let's assume that you buy a $10,000 US Treasury bond paying a rate of 8% per annum with a 20 year maturity.  If you hold that bond for 20 years you will make 8% on your investment every year and get your principal back at maturity.  Sounds pretty safe, doesn't it?  However, under certain circumstances, you could face a loss of principal.

If you unexpectedly need cash and interest rates on similar Treasuries have climbed to 10% in the market, you will not get the face value of your bond when you go to sell it.  If the market rate is now 10%, why would anyone pay face value for your bond with an 8% yield?  There are hundreds of billions of dollars of Treasuries traded every day, so it would not be hard for an investor to find that 10% yield.  To get a 10% return on your 8% bond, the buyer will pay less than its face value such that your bond will yield 10% to him or her.  In this case, the value of your 8% bond drops to $8,300.  You will have lost 17% of your investment in the safest form of debt in the world because you needed immediate cash.

Let's look at the opposite and, certainly, more pleasant scenario.  Assume that interest rates have dropped since you bought your bond.  Now the going interest rate on similar bonds is 6% in the debt market.  Since the money being generated on your bond exceeds the amount of money to be received at a market rate of 6%, you are not going to sell your Treasury at face value.  The value of your bond will have increased from $10,000 to $12,300, a 23% premium.

The risk for you, an individual bond holder, is twofold.  First, can you hold the bond to maturity?  Second, if you must sell, what has happened to interest rates in the interim?  Market interest rates fluctuate daily, and you have no way of knowing what the rate might be if and when you need to sell.

It is said that there are two constants in this life, death and taxes.  I would suggest that there is a third constant in life these days: inflation.  The loaf of bread you bought 10 years ago for $2.00 now costs more.  The purchasing power of your money has declined.  That dollar you put away in a savings account 10 years ago is worth a lot less today.  If you buy a10% bond and inflation is running at 3% each year, the real rate of return on your investment is actually 7% (10%-3%).   Your real rate of return is then reduced even further by one of the other constants in life, taxes.  If you lived through the years of high inflation in the late 70s and early 80s in the US, you know how rampant inflation can impact investments.  A 10% bond in an era of 12% inflation results in a loss of purchasing power at the rate of 2% every year, and the taxes you must pay on the interest you received will further deepen that loss.

So, even the safest investment in the world, US debt, carries risk.  Individual investors need to keep these facts in mind when they approach investing a percentage of their portfolio in debt instruments.  We will continue to look at debt as an investment in the next blog.

Comments are always welcome.