Bonds Are Riskier Than Ever. Here’s Why.

AP, Jacquelyn MartinThe U.S. Treasury Building in Washington. In investing, bonds have always had a reputation for being the safe choice. Compared to the wild oscillations one can get in the stock market, bonds appear stable and downright boring: They make predictable interest payments and eventually return the invested principal to their buyers at maturity.

Lately, though, some troubling trends have turned against bond investors. In particular, two recent events have shown just how willing the government entities that issue bonds are to put investors at risk of losing their investments.

The Debt Ceiling And You

The government shutdown in Washington has affected millions of Americans, with an estimated 800,000 federal workers having been furloughed, and many private businesses and their employees suffering from the collateral damage of shutdowns of government agencies and of federally-owned landmarks like national parks.

But of greater importance to investors around the world is the debt ceiling debate.

Under current law, the government sets a limit on the total amount of debt that it is allowed to incur. At the current rate of borrowing, the national debt will hit that limit later this month.

Until recent years, most investing analysts assumed — correctly — that lawmakers would raise the debt ceiling as necessary without much fuss. Now, though, there’s a very real possibility that Congress won’t take action, which could cause the U.S. to default on some of its debt.

Investors have reacted to that possibility. Rates on the shortest-term Treasury bills available have jumped eightfold in just the past week as those who invest in that short-term debt have to factor in the risk that they might not be repaid on time when their Treasury bills mature next month.

Moreover, foreign bondholders aren’t happy with Congress’s shenanigans over the debt situation. Chinese officials noted recently that they wanted the U.S. government to protect the safety of its bond holdings in light of the debt-ceiling deadline. Similarly, Japan, which is the second-largest foreign bondholder of U.S. Treasuries behind China, wants reassurance that a U.S. debt crisis won’t jeopardize its strategy of weakening the Japanese yen against the dollar.

Regardless, members of Congress haven’t seemed deterred by the potential impact of a bond default on investors. Despite tens of millions of Americans having a stake in Treasury debt either directly through their investments or indirectly because of the Treasury holdings that entities like pension funds own, their elected representatives aren’t rushing to resolve the debt ceiling issue.

Striking a Balance

Indeed, governments seem more willing than ever to let bondholders shoulder a share of the burdens created by our still-shaky economy.

At the local level, the bankrupt city of Stockton, Calif., issued its plan to exit legal bankruptcy proceeds late last month. The plan included forcing bond investors to accept a substantial reduction in the amount of interest they would receive on their bonds, as the city has said that it can pay less than 20 percent of the $2.9 million in annual bond-financing costs.

Bondholders won’t be the only ones hurt by that bankruptcy.

Stockton also intends to raise sales taxes in the city and has already reduced services and made employee cuts before the bankruptcy was filed. The plan does preserve pension payments to retirees, although retired workers will lose health-insurance subsidies they previously received.

Bond investors do have the right to fight the plan in bankruptcy court, arguing that they’re being treated unfairly. Increasingly, though, the concept of “fairness” that bankrupt cities and towns espouse includes having bondholders suffer losses. That’s contrary to past experience, in which bond investors could expect repayment in full before other stakeholders got any recovery.

Bonds: Know the Risks

If you thought bonds were risk-free, recent events should have you rethinking that assessment. Before you add bonds to your portfolio, make sure you understand the real and growing possibility that you might not get repaid in full or on time.

Even if the debt-ceiling debate gets resolved favorably this time around, the trend toward less protection for bond investors could nevertheless continue in the future.

You can follow Motley Fool contributor Dan Caplinger on Twitter @DanCaplinger or on Google+.

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