Most investors tend to allocate a quantity to "bonds" and then ignore them. Many think that little ever happens in the bond market and an attachment is really a bond. Investors often think that an attachment portfolio is normally pretty stable/safe and doesn't need just as much time and attention and "analysis" since the stock portion of these portfolio. Besides, bonds are sort of complicated and hard to determine 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 numerous the areas in the credit markets. Many bonds are still unattractive as investments. It's a great time for investors to examine just how much of these portfolio they have dedicated to bonds and what they own in 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 recently been above taxable Treasury bond yields.
US Treasury Bonds
High quality bonds like US treasury bonds have inked very well as investors have experienced a "flight to quality" in the markets. This has made these good quality bonds less attractive investments excited in my own opinion. Bond prices relocate the contrary direction of interest rates, and long-term (10 year) bonds are a great deal more volatile (risky) to changes in interest rates (up and down) than short-term (1-2 year) bonds. invest bonds UK 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 just about 1.6%, and 10 year treasury bonds are yielding just about 3.5%. After taxes and inflation these "safe" bonds are likely to lead to negative real returns for investors (after adjusting for inflation). Do you really want to lock in negative real after-tax returns over the next 2-10 years in your portfolio? I don't. Generally interest income on bonds is taxable as "ordinary income" at the higher federal tax rates up to 35% (US Treasury bonds are not 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. 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 bought them as a secure temporary hiding place since riskier bonds and stocks have all been declining in value recently. I do believe 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 provides definitely better returns than US treasury bonds over the next few years.
Inflation and Bonds
Rising inflation could be the #1 enemy of bond investments. Most bonds are "fixed" income investments that offer the exact same dollar value of interest income each year (and they're not adjusted upwards for inflation). Rising inflation also will lead to higher interest rates, that 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 up to 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 increase 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 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 into 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 resulted in record low interest rates on TIPS as well, making them look less attractive. TIPS provide a certain annual (real) yield above the state inflation rate (cpi). This real or after-inflation yield is locked in whenever you buy, and today 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. Many people believe 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 types of bonds (which will probably incur losses).
The US economy and Treasury bond investments
If the economy falls right into a hard recession over the next 6 months interest rates could go still lower, leading to gains in treasury bond prices from current levels. That (recession) could be the scenario that is necessary to make money in treasury bonds over the next 6 months. The US economy happens to be very near or in a recession right now.
