Most investors have a tendency to allocate a quantity to "bonds" and then forget about them. Many believe very little ever happens in the bond market and a bond is just a bond. Investors often believe a bond portfolio is typically pretty stable/safe and doesn't need the maximum amount of time and attention and "analysis" whilst the stock portion of these portfolio. Besides, bonds are sort of complicated and hard to figure out for most investors. There has 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 the areas in the credit markets. Many bonds are still unattractive as investments. It is a good time for investors to review how much of these portfolio they've dedicated to bonds and what they own inside their bond portfolios.
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 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 high quality bonds less attractive investments anticipating in my own opinion. Bond prices relocate the alternative 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. bonds to invest in the UK 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 likely end up in negative real returns for investors (after adjusting for inflation). Would you genuinely wish to lock in negative real after-tax returns over another 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 around 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 get 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 purchased them as a safe temporary hiding place since riskier bonds and stocks have all been declining in value recently. I do believe cash/money market funds will likely provide better returns than US treasury bonds over another year, with less interest rate risk. I also think stocks provides definitely 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 offering the exact same dollar value of interest income annually (and they're not adjusted upwards for inflation). Rising inflation also tends to end up in higher interest rates, which in turn 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 around new record levels of $100+ per barrel in the last few months. Other commodity prices such as for example wheat, corn, gold, and iron ore have spiked as well in the last 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% 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 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 is also inflationary as goods imported into 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 because of the 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 official inflation rate (cpi). This real or after-inflation yield is locked in when 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 for 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 utilized by the federal 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 probably incur losses).
The US economy and Treasury bond investments
If the economy falls in to a hard recession over another 6 months interest rates might go still lower, resulting in gains in treasury bond prices from current levels. That (recession) may be the scenario that's necessary to make money in treasury bonds over another 6 months. The US economy is very near or in a recession right now.
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