Most investors tend to allocate a specific amount to "bonds" and then forget about them. Many believe very little ever happens in the bond market and an attachment is just a bond. Investors often believe an attachment portfolio is usually pretty stable/safe and doesn't need the maximum amount of time and attention and "analysis" since the stock portion of their portfolio. Besides, bonds are sort of complicated and hard to determine for many 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 areas in the credit markets. Many bonds are currently unattractive as investments. It is a great time for investors to examine just how much of their portfolio they have dedicated to bonds and what they own within their bond portfolios.
Three extremely unusual bond market facts recently:
1. 10-year Treasury bond yields are currently 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 recently been above taxable Treasury bond yields.
US Treasury Bonds
High quality bonds like US treasury bonds have done very well as investors experienced a "flight to quality" in the markets. It's made these high quality bonds less attractive investments looking forward in my own 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. 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 will likely end up in negative real returns for investors (after adjusting for inflation). Do you really want 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 as much as 35% (US Treasury bonds are not taxed at the state level). bonds 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 obtain an estimated real after-tax return of -.7% per year. The actual 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 nice looking forward. Investors have bought them as a secure temporary hiding place since riskier bonds and stocks have all been declining in value recently. I think 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 much better returns than US treasury bonds over another few years.
Inflation and Bonds
Rising inflation could be the #1 enemy of bond investments. Most bonds are "fixed" income investments that provide the exact same dollar value of interest income annually (and they're not adjusted upwards for inflation). Rising inflation also has a tendency 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 many signs that inflation is increasing in the USA. The price tag on oil has shot as much as new record degrees 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 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'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 in the last 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 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 a variety (regular and inflation-protected) and the increased concerns about rising inflation. This stampede has resulted in 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 right now 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 hasn't happened before. Lots of people feel that the inflation measure utilized by the federal government for TIPS bonds (cpi) understates the true inflation rate in the economy. If inflation is headed to 4%-5%+ TIPS will significantly outperform most 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 another 6 months interest rates might go still lower, causing gains in treasury bond prices from current levels. That (recession) could be the scenario that is necessary to make profit treasury bonds over another 6 months. The US economy is currently very near or in a recession right now.
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