Most investors often allocate a specific amount to "bonds" and then forget about them. Many believe that not much ever happens in the bond market and a connection is just a bond. Investors often believe that a connection portfolio is normally pretty stable/safe and doesn't need just as much time and attention and "analysis" since the stock portion of the portfolio. Besides, bonds are type of complicated and hard to determine for a lot of investors. invest bonds UK There has been some interesting and unprecedented things going on in the bond market over the past couple of months that merit investor's full attention. This all started with the sub-prime mortgage meltdown and has quickly spread to many other places in the credit markets. Many bonds are now unattractive as investments. It's a good time for investors to review how much of the portfolio they have focused on bonds and what they own within their bond portfolios.
Three extremely unusual bond market facts recently:
1. 10-year Treasury bond yields are now 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
Good quality bonds like US treasury bonds have done well as investors experienced a "flight to quality" in the markets. It's made these good quality bonds less attractive investments excited within my opinion. Bond prices move around in the contrary direction of interest rates, and long-term (10 year) bonds are a 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 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 bring about negative real returns for investors (after adjusting for inflation). Can you genuinely wish to lock in negative real after-tax returns over the following 2-10 years in your portfolio? I don't. Generally interest income on bonds is taxable as "ordinary income" at the larger federal tax rates around 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 true after-tax return on 2-year treasury bonds is approximately -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 couple of 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 believe cash/money market funds are likely to provide better returns than US treasury bonds over the following year, with less interest rate risk. I also think stocks provides definitely better returns than US treasury bonds over the following few years.
Inflation and Bonds
Rising inflation could be the #1 enemy of bond investments. Most bonds are "fixed" income investments that provide the same dollar value of interest income each year (and they're not adjusted upwards for inflation). Rising inflation also will bring about higher interest rates, that causes bond prices to decline (remember bond prices and interest rates move around in opposite directions). There are lots of signs that inflation is increasing in the USA. The buying price of oil has shot around 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 buying price of 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 has 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 to the US cost more in dollars.
What about TIPS (US Treasury inflation protected bonds)?
If inflation is picking up shouldn't we buy TIPS? Inflation protected bonds have performed well recently as well because of 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 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 to 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 actual inflation rate in the economy. If inflation is headed to 4%-5%+ TIPS will significantly outperform almost every other kinds of bonds (which will likely incur losses).
The US economy and Treasury bond investments
If the economy falls right into a hard recession over the following 6 months interest rates may go still lower, causing gains in treasury bond prices from current levels. That (recession) could be the scenario that is necessary to create profit treasury bonds over the following 6 months. The US economy happens to be very near or in a recession right now.
