Bond Investing – Current Bond Turmoil

Bond Investing – Current Bond Turmoil

Most investors tend to allocate a certain amount to “bonds” and then forget about them. Many think that not much ever happens in the bond market and a bond is a bond. Investors often think that a bond portfolio is typically pretty stable/safe and doesn’t need as much time and attention and “examination” as the stock portion of their portfolio. Besides, bonds are kind of complicated and hard to figure out for many investors. There have been some interesting and unheard of things going on in the bond market over the past few months that merit investor’s complete attention. This all started with the sub-chief mortgage meltdown and has quickly spread to many other areas in the credit markets. Many bonds are currently unattractive as investments. It is a good time for investors to review how much of their portfolio they have dedicated to bonds and what they own in their bond portfolios.

Three extremely uncommon bond market facts recently:

1. 10-year Treasury bond yields are currently below the inflation rate (cpi). Very scarce.

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 have had a “flight to quality” in the markets. This has made these high quality bonds less attractive investments looking forward in my opinion. Bond prices move in 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 only about 1.6%, and 10 year treasury bonds are yielding only about 3.5%. After taxes and inflation these “safe” bonds are likely to consequence 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 higher federal tax rates up to 35% (US Treasury bonds are not 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 about -1.9% (assuming 3% inflation). That is doubtful 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 few months don’t really look so great looking forward. Investors have bought them as a safe permanent hiding place since riskier bonds and stocks have all been declining in value recently. I think 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 will provide much better returns than US treasury bonds over the next few years.

Inflation and Bonds

Rising inflation is 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 are not modificated upwards for inflation). Rising inflation also tends to consequence in higher interest rates, which causes bond prices to decline (remember bond prices and interest rates move in opposite directions). There are many signs that inflation is increasing in the USA. The price of oil has shot up to new record levels of $100+ per barrel over the past few months. Other commodity prices such as wheat, corn, gold, and iron ore have spiked in addition over the past year. The price of things such as healthcare, college education, and food continue to increase in addition. 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 money supply, and provide fiscal stimulus (rebates) to the economy typically rule to higher expected future inflation (and interest rates). The US dollar has weakened considerably over the past year relative to other currencies. A weaker US dollar is also inflationary as goods imported into 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 very well recently in addition due to 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 resulted in record low interest rates on TIPS in addition, making them look less attractive. TIPS offer a certain annual (real) provide above the official inflation rate (cpi). This real or after-inflation provide is locked in when you buy, and right now 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 to their historical yields of around 2.0%. Negative interest rates on TIPS bonds has never happened before. Many people believe that the inflation measure used by the government for TIPS bonds (cpi) understates the true inflation rate in the economy. If inflation is headed to 4%-5%+ TIPS will considerably outperform most other types of bonds (which will likely incur losses).

The US economy and Treasury bond investments

If the economy falls into a hard recession over the next 6 months interest rates could go nevertheless lower, resulting in gains in treasury bond prices from current levels. That (recession) is the scenario that is necessary to make money in treasury bonds over the next 6 months. The US economy is currently very near or in a recession right now.

Taking a longer-term outlook I expect the economy to retrieve over the next 12-18 months from the current very ineffective (recessionary?) levels. A strengthening US economy often results in rising interest rates (and consequently declining bond prices). As the US economy picks up over the next year the fed will likely start increasing short-term interest rates just as fast as they have been cutting them over the past 6 months. I think there is a good chance that treasury bonds will decline in value over the next 12 months as interest rates increase (due to rising inflation and economic recovery). If you buy treasury bonds right now you are locking in very low interest rates (1.6%-3.5%) which are negative after taxes and inflation, and you are at risk of capital losses if inflation and interest rates pick up over the next year. As the US economy and credit market turmoil stabilizes, investors who have rushed into treasury bonds for cover will little by little sell their treasuries and venture back into corporate bonds and other areas (mortgage bonds) that have seemed too risky recently. As investors sell their treasury bonds to move back into other types of riskier bonds this will put downward pressure (losses) on treasury bond prices and upward pressure on corporate (and other) bond prices. Some investors are wondering if there is a “bubble” in Treasury bond prices right now.

Municipal Bonds

Muni bonds currently offer higher yields than US treasury bonds (an extremely uncommon situation) and better tax advantages (they are exempt from federal taxes). Muni bonds historically have traded at 10%-20%+ discounts to treasury yields. Muni bonds have sold off recently on concerns about municipal governments having a worse financial situation with the slowing economy, forced selling by hedge funds, and concerns about the municipal bond insurance companies (Ambac Financial and MBIA) losing their own credit ratings and having financial troubles. If US personal tax rates go up over the next 2 years (which seems likely with a new administration) that will make Muni bonds already more attractive relative to taxable bonds. Remember that it doesn’t make sense to own tax-free Muni bonds in your 401K/IRA/403b qualified accounts.

Other Bond Types

There are many other types of fixed income investments such as corporate bonds, high provide (junk) bonds, mortgage bonds, convertibles, money markets, CD’s, bond hedge funds, and international bonds. They each have rare traits that cause them to provide considerably different total returns.

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