[Insight & Opinion] The Meaning of Bond Investment and Safe Assets

Although temporarily stalled due to unrest originating in the Middle East, the yield on the U.S. 10-year Treasury note is currently at its highest level in 16 years. Investors are increasingly troubled. Rising interest rates mean falling bond prices. The price of long-term U.S. Treasury bonds is now at its lowest point in 16 years. When prices plummet, investors who bought U.S. Treasuries cannot avoid unrealized losses. Domestic and international exchange-traded funds (ETFs) investing in U.S. long-term Treasuries are consecutively hitting new lows. The ETF most purchased by domestic investors reportedly has fallen more than 35%. The domestic bond market is not doing well either. While the average return of equity funds exceeded 19% in the first half of this year, the average return of bond funds remained just above 2%. Investors may question whether bonds are truly safe assets.

To get straight to the point, bonds are indeed safe assets. In investment theory, the definition of a safe asset simply means it does not have high volatility. It only implies that it is relatively less affected by external shocks. Naturally, there is risk from price fluctuations. Even gold or the U.S. dollar, often cited as representative safe assets, have historically shown considerable volatility. Of course, there is no need to worry about the U.S. government defaulting on its debt when buying U.S. Treasuries. The U.S. can simply print dollars to repay its debts. However, this means only that there is literally no risk of default; yields fluctuate, and bond prices change accordingly. If your strategy is to hold until maturity to receive fixed interest, you need not worry about price changes. But if you need to sell and liquidate before maturity, you must bear the risk of price fluctuations. When classifying investment products as safe or risky assets, the real danger may be failing to properly recognize the risks inherent in safe assets.

Investor interest in bonds is rational. The appeal lies in the high interest income expected in a high-rate environment and the potential price appreciation when interest rates fall. Over the long term, market interest rates tend to be slightly below nominal growth rates. Considering macroeconomic factors, market interest rates are expected to decline in the medium to long term. Many investors currently believe the U.S. Treasury shock will end soon. The long-term outlook is clear: with ongoing aging and low growth, market interest rates will eventually fall. However, investing in bonds for capital gains is a way of increasing risk while buying what is considered a safe asset. Bonds are originally products focused on fixed income through interest. Moreover, long-term bond investment requires cautious approach. The longer the time horizon, the greater the likelihood of unforeseen events.

It goes without saying that to aim for capital gains in bond investing, interest rates must have peaked and be on the decline. This means timing the market well, which is difficult even for experts. The Federal Reserve (Fed) may not be as aggressive in cutting rates as expected. If you already hold U.S. long-term Treasury-related products, it is better to take a long-term view. For medium- to long-term investors, the current interest rate level is reasonable. In the U.S., bonds typically become substitutes for stocks when yields exceed the mid-4% range. This means they offer competitive returns compared to the expected returns of the stock market, which requires bearing high volatility.

One advantage that ordinary investors using their own money have over professionals managing others’ money is the ability to endure time on their own terms. This is a far greater advantage than commonly thought.

Kim Sang-cheol, Economic Commentator