Most investors tend to allocate a certain amount to "bonds" and then ignore them. Many genuinely believe that little ever happens in the bond market and an attachment is really a bond. Investors often genuinely believe that an attachment portfolio is typically pretty stable/safe and doesn't need just as much time and attention and "analysis" as the stock portion of their portfolio. Besides, bonds are kind of complicated and hard to determine for several investors. There were some interesting and unprecedented things going on in the bond market over the past month or two that merit investor's full attention. This all started with the sub-prime mortgage meltdown and has quickly spread to numerous other places in the credit markets. Many bonds are currently unattractive as investments. It is a great time for investors to review just how much of their portfolio they've 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 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 already been above taxable Treasury bond yields.
US Treasury Bonds
Top quality bonds like US treasury bonds have inked very well as investors have had a "flight to quality" in the markets. It has made these top quality bonds less attractive investments looking forward within my opinion. Bond prices relocate the opposite 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 just about 1.6%, and 10 year treasury bonds are yielding just about 3.5%. After taxes and inflation these "safe" bonds will probably 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 the next 2-10 years in your portfolio? I don't. In general interest income on bonds is taxable as "ordinary income" at the bigger federal tax rates up to 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. 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 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 over the past month or two don't really look so nice looking forward. Investors have obtained 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 probably provide better returns than US treasury bonds over the next year, with less interest rate risk. I also think stocks can provide much 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 provide exactly the same dollar value of interest income annually (and they are not adjusted upwards for inflation). Rising inflation also will end up in higher interest rates, that 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 up to new record degrees of $100+ per barrel over the past few months. Other commodity prices such as for instance wheat, corn, gold, and iron ore have spiked as well over the past year. The price tag on things such as for instance 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 amount of 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 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 very well recently as well because of the rush to the safety/liquidity of US treasury bonds of all types (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 official 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 believe that the inflation measure used by the us 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 kinds of bonds (which will probably incur losses). premium bonds UK invest
The US economy and Treasury bond investments
If the economy falls into a hard recession over the next 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 is necessary to produce profit 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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