Most investors have a tendency to allocate a quantity to "bonds" and then just forget about them. Many genuinely believe that little ever happens in the bond market and a bond is just a bond. Investors often genuinely believe that a bond portfolio is typically pretty stable/safe and doesn't need as much time and attention and "analysis" whilst the stock portion of their portfolio. Besides, bonds are type of complicated and hard to figure out for a lot of investors. There has been some interesting and unprecedented things going on in the bond market over the past few 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 is a great time for investors to examine how much of their portfolio they have focused on bonds and what they own inside their bond portfolios.
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 also been above taxable Treasury bond yields.
US Treasury Bonds
High quality bonds like US treasury bonds did perfectly as investors experienced a "flight to quality" in the markets. It has made these top quality bonds less attractive investments anticipating in my opinion. Bond prices relocate the contrary direction of interest rates, and long-term (10 year) bonds are a whole lot 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. Today 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 likely bring about negative real returns for investors (after adjusting for inflation). Would you really want to lock in negative real after-tax returns over the following 2-10 years in your portfolio? I don't. Generally speaking interest income on bonds is taxable as "ordinary income" at the bigger federal tax rates as much as 35% (US Treasury bonds are not taxed at their state level). bonds to invest in 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 approximately -1.9% (assuming 3% inflation). That's 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 few months don't really look so great looking forward. Investors have purchased them as a safe temporary hiding place since riskier bonds and stocks have all been declining in value recently. I believe cash/money market funds will likely provide better returns than US treasury bonds over the following year, with less interest rate risk. I also think stocks can provide much 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 that offer the same dollar value of interest income each year (and they are not adjusted upwards for inflation). Rising inflation also has a tendency to bring about higher interest rates, which causes bond prices to decline (remember bond prices and interest rates relocate 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 levels of $100+ per barrel over the past few months. Other commodity prices such as wheat, corn, gold, and iron ore have spiked as well over the past year. The price tag on things such as 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's 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 over the past year relative to other currencies. A weaker US dollar is also inflationary as goods imported to the US cost more in dollars.
How about TIPS (US Treasury inflation protected bonds)?
If inflation is picking up shouldn't we buy TIPS? Inflation protected bonds have performed perfectly recently as well as a result of rush to the safety/liquidity of US treasury bonds of all kinds (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 state inflation rate (cpi). This real or after-inflation yield is locked in once you buy, and at this time it's 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 utilized by the us government for TIPS bonds (cpi) understates the real inflation rate in the economy. If inflation is headed to 4%-5%+ TIPS will significantly outperform most other kinds of bonds (which will likely incur losses).
The US economy and Treasury bond investments
If the economy falls right into a hard recession over the following 6 months interest rates could go still lower, resulting in gains in treasury bond prices from current levels. That (recession) may be the scenario that's necessary to produce money in treasury bonds over the following 6 months. The US economy is currently very near or in a recession right now.
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