One of my readers asked me a question that I feel warrants a proper response here. 

He asked me whether I’m afraid of a bond market crash, and the reader wondered whether bond markets can plunge like stock markets.

The answer to both of those questions is no.

 Bonds have had a great run lately, as people have poured money into bonds to escape the uncertainty of the stock markets.  Bond prices have risen, and yields (interest rates) are currently low…much as a result.

 But bonds move so little.

For a reference, check out the chart below.

Barclays 1-3 Year Treasury Bond (NYSEArca) (2NOV12)This is a chart of the S&P 500 (in green) compared to the U.S. short-term government bond index (in blue).  Please note that these movements do not include interest rates on the bonds, nor do they include dividends for the stocks.

Notice that the S&P 500 gained 65% from 2003, then dropped 20% below the 2003 price, then surged more than 80% from that low.  This was a volatile period for stocks.

Bonds?  Yeah, they were volatile too.  You’ve heard it in the news.  Check out that blue line.  Not including interest, U.S. short term bonds are up about 6%, overall,  since 2003.  Note their relative stability compared to the stock index.  The bond indexed line (in blue) would normally be running almost perfectly flat.  It shouldn’t normally rise or fall much at all.  It should be relatively flat as it throws off interest, but that’s all.  Its popularity has seen it rise, and this is what people are afraid of.  Bonds prices could fall.

If bonds drop (let’s say) 6% people will freak, news headlines will run rampant, and it will be called the great bond crash.  If that happens, so what?  Bonds will be coming back down to earth.  You might not make money on bonds for the next couple of years (assuming a 3% interest rate per year and a sudden 6% price decrease) but the bonds you bought after the bond market “crash” would then earn higher interest yields.

If bonds become really unpopular, they could fall 10%.  Such a fall (in stocks) wouldn’t create too much concern in the stock market world.  But for bonds, this would be huge news.   If that were to occur, the interest yield on newly purchased bonds would increase.

This is how it works.  Assume that a bond index is priced at $100 a unit, and it pays $3 per year in interest for a 3% rate of return.

If the bond price fell 10% to $90, the bond index would still pay $3 per year in interest, but $3 is roughly 3.4% of $90, so the interest yield would rise for new purchasers.

Let bonds fall.  In fact, let them fall hard. 

I’ll be ready to rebalance my portfolio, as I always do, greedily adding what the world becomes fearful of.  And in the end, I’ll reap some nice profits.

Over the long term, you could do the same.

Rebalance, dollar cost average, stay the course, and ignore predictions.