Most investors tend to allocate a quantity to "bonds" and then just forget about them. Many believe that little ever happens in the bond market and a relationship is really a bond. Investors often believe that a relationship portfolio is normally pretty stable/safe and doesn't need as much time and attention and "analysis" because the stock portion of the portfolio. Besides, bonds are sort of complicated and hard to figure out for several investors. There were some interesting and unprecedented things going on in the bond market over the past month or two that merit investor's full attention. This all started with the sub-prime mortgage meltdown and has quickly spread to numerous other places in the credit markets. Many bonds are still unattractive as investments. It's a great time for investors to examine just how much of the portfolio they've dedicated to bonds and what they own inside their bond portfolios. invest in premium bonds
Three extremely unusual bond market facts recently:
1. 10-year Treasury bond yields are still 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
High quality bonds like US treasury bonds did very well as investors have experienced a "flight to quality" in the markets. It has made these top quality bonds less attractive investments anticipating in my own opinion. Bond prices move in the contrary direction of interest rates, and long-term (10 year) bonds are far 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 to surprisingly low levels. Right now 2 year treasury bonds are yielding no more than 1.6%, and 10 year treasury bonds are yielding no more than 3.5%. After taxes and inflation these "safe" bonds will probably result in negative real returns for investors (after adjusting for inflation). Can you really want to lock in negative real after-tax returns over the following 2-10 years in your portfolio? I don't. In general interest income on bonds is taxable as "ordinary income" at the higher federal tax rates as much as 35% (US Treasury bonds aren't taxed at the state level). The after-tax return of a 10-year treasury bond is estimated at 3.5% * (1-.35) = 2.27% per year. If you subtract the recent inflation rate of around 3% you receive an estimated real after-tax return of -.7% per year. The true 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 over the past month or two don't really look so great looking forward. Investors have obtained them as a secure temporary hiding place since riskier bonds and stocks have all been declining in value recently. I believe cash/money market funds will probably provide better returns than US treasury bonds over the following year, with less interest rate risk. I also think stocks can provide far better returns than US treasury bonds over the following few years.
Inflation and Bonds
Rising inflation may be the #1 enemy of bond investments. Most bonds are "fixed" income investments offering exactly the same dollar value of interest income every year (and they are not adjusted upwards for inflation). Rising inflation also tends to result in higher interest rates, that causes bond prices to decline (remember bond prices and interest rates move in opposite directions). There are numerous signs that inflation is increasing in the USA. The price tag on oil has shot as much as new record quantities of $100+ per barrel over the past few months. Other commodity prices such as for example wheat, corn, gold, and iron ore have spiked as well over the past year. The price tag on things such as for example healthcare, college education, and food continue to improve as well. The "headline" consumer price index (cpi) has risen 4.3% over the past 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 cash 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 over the past year in accordance with other currencies. A weaker US dollar can be inflationary as goods imported into the US cost more in dollars.
Think about TIPS (US Treasury inflation protected bonds)?
If inflation is picking right up shouldn't we buy TIPS? Inflation protected bonds have performed very well recently as well as a result of rush to the safety/liquidity of US treasury bonds of a variety (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 whenever you buy, and at this time 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 with their historical yields of around 2.0%. Negative interest rates on TIPS bonds hasn't happened before. Lots of people believe that the inflation measure employed by the government for TIPS bonds (cpi) understates the real inflation rate in the economy. If inflation is headed to 4%-5%+ TIPS will significantly outperform almost every other forms of bonds (which will more than likely incur losses).
The US economy and Treasury bond investments
If the economy falls in to a hard recession over the following 6 months interest rates might go still lower, causing gains in treasury bond prices from current levels. That (recession) may be the scenario that's necessary to make money in treasury bonds over the following 6 months. The US economy is currently very near or in a recession right now.
