Bonds, once a safe haven, may be next big risk

Investors are well trained to worry about stock market crashes. But what if the next big risk lurking on the horizon is in bonds?

Wall Street firms and many well-known market strategists are sounding alarms about these seemingly benign — even boring — investments. A 30-year bull market in bonds, which drove prices sky-high as interest rates plunged, is ending, they say.

As it vanishes, so will the safe haven investors turned to in the financial crisis.

“Individual investors are going to be stuck between a rock and a hard place,’’ said Andrew Lo, a Massachusetts Institute of Technology finance professor and chairman and chief investment strategist at the Cambridge investment firm AlphaSimplex Group.

Particularly for retirees, who often devote a larger portion of their investments to bonds, “Frankly I don’t know what they’re going to do,’’ Lo said.

Bond prices go down when interest rates rise. Right now, rates on all kinds of bonds, from government securities to corporate debt, are at or near historic lows and have almost no place to go but up. That may mean troubling times ahead for investors who have come to rely on bonds as a reliable place to hide from the risks of the stock market.

If bond portfolios get hit hard, that could mark a third major setback for investors since 2001, following two dramatic stock market plunges. A serious bond market decline would not take place all at once, like a bad session in the stock market. But bond investors could face a slow, steady bleed for years, with annual losses of about 1 to 2 percent.

A scenario like that has not played out since the 1940s. That’s the last time 10-year US Treasury notes offered interest rates below 2 percent, as they have recently. From there, rates rose slowly for years, ­accelerating to double-digit levels by the early 1980s.

Another market like that could make bonds rocky investments for a long period.

MFS Investment Management, a Boston mutual fund firm, estimates it like this:

Assume that over the next decade, rates on 10-year Treasuries rise to 5 percent, their average level over the last century. That would translate to a 0.6 percent annual loss, a hit of more than 20 percent to an investor’s wealth over 10 years, taking into account inflation, said Benjamin Nastou, a portfolio manager at MFS.

In other words, a $10,000 portfolio invested in 10-year bonds would lose $2,000 in value, including inflation. If that same increase in interest rates were to happen in just five years, Nastou calculates, that would mean a 2.2 percent annual loss, adding up to $2,300.

Investors are not used to this. Since 1981, bond funds have lost money in only two years. That includes 2008, when virtually all investments collapsed.

Mutual funds that own bonds have been especially reliable sources of investment gains in recent years, as the Federal Reserve pursued a policy of keeping interest rates low to boost the economy. But rates are expected to rise once the economy improves and the Fed backs away from its strategy of pumping billions of dollars into the financial system.

“It can get dangerous for bond investors,” said ­Mohamed El-Erian, the chief executive of Pimco, a West Coast investment firm that specializes in bonds.

Merrill Lynch is calling it the “Great Rotation,” from bonds to stocks.

Bill Gross, who runs the largest bond fund in the world at Pimco, recently warned that the bull market for bonds is ending, and that stocks are more attractive. Large investors, such as pension funds, are preparing to shift away from bonds due to the growing risks, which could further fuel a drop in bonds.

Analysts are concerned about average investors who have moved heavily into bond funds since 2008. Investors have poured $894 billion into bond funds over the last four years, twice as much as over the prior 16 years combined, according to Morningstar Inc., a Chicago firm that tracks mutual funds.

“You’ve had people running from the volatility of equities,’’ said John Sweeney, an executive vice president in Fidelity Investments’s retirement group. But as the herd has moved into bonds, he said, they face new risks. Fidelity and other firms are not recommending a wholesale flight from bonds. Instead, they suggest some investors — depending on age — might be advised to reduce their bond holdings.

For instance, a retiree might have half his money in stocks and half in bonds. It may not make sense to move any of that money into stocks, which are inherently risky.

But an investor in her forties and starting with a similar portfolio might want to gradually shift more of the money into stocks.

No one can predict precisely when interest rates will rise, however, and it’s a bad idea to try to time the market, Sweeney noted.

“We’ve been concerned about rising rates for the past few years, and they haven’t materialized yet,’’ he said.

John Ameriks, the head of Vanguard Group’s Investment Counseling & Research Group, warned against jumping the gun too soon on bonds. But, he said, “I think it’s good news that people are focused on the risk in the bond market. It’s there.”