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  GWG L bonds attorney” often think that a bond portfolio is typically pretty stable/safe and doesn’t need as much time and attention and “analysis” 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 unprecedented things going on in the bond market over the past few months that merit investor’s full attention. This all started with the sub-prime 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 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 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 result 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 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 few months don’t really look so great looking forward. Investors have bought them as a safe temporary 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 adjusted upwards for inflation). Rising inflation also tends to result 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 as well over the past year. The price of things such as healthcare, college education, and food continue to increase 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 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 relative to other currencies. A weaker US dollar is also inflationary as goods imported into the US cost more in dollars.



Leave a Comment