Long-term bonds appear risky

The stock market plunge that followed the destruction of the World Trade Center caused many investors to look more closely at bonds as a potential safe haven. But they may not be as safe as you think.

Bond prices move in the opposite direction to interest rates. So when rates fall, bond prices tend to rise. The problem is that all interest rates do not move in lock-step, so neither do bond prices.

In the aftermath of the attacks, central banks around the world moved to ease short-term rates. That had the effect of increasing the prices of bonds with maturities out to about two years.

However, long-term rates actually rose. Reason: many investors expect that the economy will stabilize in 2002, which will lead to a reversal of the current rate trend. The bond market is signaling that it does not expect rates to stay this low for long.

If bond traders are right, the risk of investing in long-term bonds at this time is quite high. The prices of those bonds will drop as rates rise in the future.

The only scenario in which long-term bonds look good going out more than two years is one of deep and prolonged recession and deflation. In that case, the crent yields on long-term government bonds, which are in the 5.5% – 6% range, could fall, driving up the market price of the issues.

If you are very pessimistic about the economic outlook and are willing to take the risk., then buy long bonds. But the message for conservative investors is simple: accept the low yields and stay short term.