Most investors often allocate a quantity to "bonds" and then forget about them. Many believe that little ever happens in the bond market and a connection is a bond. Investors often believe that a connection portfolio is usually pretty stable/safe and doesn't need the maximum amount of time and attention and "analysis" as the stock portion of their portfolio. Besides, bonds are kind of complicated and hard to find out for a lot of investors. There were some interesting and unprecedented things going on in the bond market in the last couple of months that merit investor's full attention. This all started with the sub-prime mortgage meltdown and has quickly spread to numerous the areas in the credit markets. Many bonds are unattractive as investments. It's a good time for investors to examine simply how much of their portfolio they've specialized in bonds and what they own within their bond portfolios.
Three extremely unusual bond market facts recently:
1. 10-year Treasury bond yields are 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 been recently above taxable Treasury bond yields.
US Treasury Bonds
Good quality bonds like US treasury bonds did very well as investors have experienced a "flight to quality" in the markets. It has made these good quality bonds less attractive investments anticipating in my own opinion. Bond prices relocate the contrary 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 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 are likely to bring about negative real returns for investors (after adjusting for inflation). Do you actually want to lock in negative real after-tax returns over the next 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 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 get an estimated real after-tax return of -.7% per year. The real after-tax return on 2-year treasury bonds is 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 couple of months don't really look so great looking forward. Investors have bought 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 the next year, with less interest rate risk. I also think stocks can provide definitely better returns than US treasury bonds over the next few years.
Inflation and Bonds
Rising inflation may be the #1 enemy of bond investments. Most bonds are "fixed" income investments that offer the exact same dollar value of interest income annually (and they are not adjusted upwards for inflation). Rising inflation also has a tendency to bring about higher interest rates, which in turn causes bond prices to decline (remember bond prices and interest rates relocate 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 wheat, corn, gold, and iron ore have spiked as well in the last year. The price tag on things such as healthcare, college education, and food continue to boost as well. invest bonds The "headline" consumer price index (cpi) has risen 4.3% in the last 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 cash supply, and provide fiscal stimulus (rebates) to the economy typically lead to raised 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 be inflationary as goods imported in to the US cost more in dollars.
How 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 due to the rush to the safety/liquidity of US treasury bonds of all sorts (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 give you a certain annual (real) yield above the official inflation rate (cpi). This real or after-inflation yield is locked in once 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 to their historical yields of around 2.0%. Negative interest rates on TIPS bonds never happened before. Many individuals think 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 types of bonds (which will more than likely incur losses).
The US economy and Treasury bond investments
If the economy falls into a hard recession over the next 6 months interest rates may go still lower, causing 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 next 6 months. The US economy happens to be very near or in a recession right now.
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