Most investors have a tendency to allocate a quantity to "bonds" and then ignore them. Many genuinely believe that very little ever happens in the bond market and a relationship is really a bond. Investors often genuinely believe that a relationship portfolio is normally pretty stable/safe and doesn't need just as much time and attention and "analysis" as the stock portion of their portfolio. Besides, bonds are sort of complicated and hard to figure out for all investors. There have been some interesting and unprecedented things going on in the bond market in the last several months that merit investor's full attention. This all started with the sub-prime mortgage meltdown and has quickly spread to many other places in the credit markets. Many bonds are now unattractive as investments. It's a great time for investors to examine simply how much of their portfolio they have specialized in bonds and what they own in their bond portfolios. premium bonds invest UK
Three extremely unusual bond market facts recently:
1. 10-year Treasury bond yields are now below the inflation rate (cpi). Very rare.
2. Some inflation protected bond yields have gone negative. Never happened before.
3. Tax-free municipal bond yields have already been above taxable Treasury bond yields.
US Treasury Bonds
Top quality bonds like US treasury bonds have done very well as investors have experienced a "flight to quality" in the markets. It has made these top quality bonds less attractive investments looking forward in my own opinion. Bond prices move around in the opposite direction of interest rates, and long-term (10 year) bonds are much more volatile (risky) to changes in interest rates (up and down) than short-term (1-2 year) bonds. Investors have sold riskier bonds in the recent credit market panic and rushed into US treasury bonds pushing these bond prices up, and pushing the interest rate (yields) on these bonds down seriously to surprisingly low levels. Right now 2 year treasury bonds are yielding only about 1.6%, and 10 year treasury bonds are yielding only about 3.5%. After taxes and inflation these "safe" bonds are likely to bring about negative real returns for investors (after adjusting for inflation). Can you actually want to lock in negative real after-tax returns over another 2-10 years in your portfolio? I don't. Generally interest income on bonds is taxable as "ordinary income" at the bigger federal tax rates as much as 35% (US Treasury bonds aren't taxed at their state level). The after-tax return of a 10-year treasury bond is estimated at 3.5% * (1-.35) = 2.27% per year. In the event that you subtract the recent inflation rate of around 3% you receive an estimated real after-tax return of -.7% per year. The real after-tax return on 2-year treasury bonds is all about -1.9% (assuming 3% inflation). That is unlikely to satisfy many people's investment goals and retirement dreams. These "safe" investments in US treasury bonds that investors have rushed into in the last several months don't really look so great looking forward. Investors have obtained them as a safe temporary hiding place since riskier bonds and stocks have all been declining in value recently. I think cash/money market funds are likely to provide better returns than US treasury bonds over another year, with less interest rate risk. I also think stocks can provide much better returns than US treasury bonds over another few years.
Inflation and Bonds
Rising inflation may be the #1 enemy of bond investments. Most bonds are "fixed" income investments that provide exactly the same dollar value of interest income annually (and they're not adjusted upwards for inflation). Rising inflation also tends to bring about higher interest rates, which in turn causes bond prices to decline (remember bond prices and interest rates move around in opposite directions). There are lots of signs that inflation is increasing in the USA. The price tag on oil has shot as much as new record levels of $100+ per barrel in the last few months. Other commodity prices such as for instance wheat, corn, gold, and iron ore have spiked as well in the last year. The price tag on things such as for instance healthcare, college education, and food continue to increase as well. The "headline" consumer price index (cpi) has risen 4.3% in the last 12 months (as of January), but excluding oil and food it has been up 2.7%. The government's recent actions to cut short-term interest rates, increase the money supply, and provide fiscal stimulus (rebates) to the economy typically lead to higher expected future inflation (and interest rates). The US dollar has weakened significantly in the last year in accordance with other currencies. A weaker US dollar can also be inflationary as goods imported in to the US cost more in dollars.
Think about TIPS (US Treasury inflation protected bonds)?
If inflation is picking up shouldn't we buy TIPS? Inflation protected bonds have performed very well recently as well because of the rush to the safety/liquidity of US treasury bonds of all types (regular and inflation-protected) and the increased concerns about rising inflation. This stampede has triggered record low interest rates on TIPS as well, making them look less attractive. TIPS offer a certain annual (real) yield above the official inflation rate (cpi). This real or after-inflation yield is locked in once you buy, and today it is very small. On many TIPS bonds the interest rate has fallen to about zero (and some have amazingly dropped to slightly below zero), compared for their historical yields of around 2.0%. Negative interest rates on TIPS bonds never happened before. Lots of people think that the inflation measure used by the government for TIPS bonds (cpi) understates the actual inflation rate in the economy. If inflation is headed to 4%-5%+ TIPS will significantly outperform most other types of bonds (which will probably incur losses).
The US economy and Treasury bond investments
If the economy falls into a hard recession over another 6 months interest rates could go still lower, causing gains in treasury bond prices from current levels. That (recession) may be the scenario that is necessary to make money in treasury bonds over another 6 months. The US economy happens to be very near or in a recession right now.
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