Bonds – Is The Party Over?

  Near the end of 2009 and as recently as April of this year professional money managers, advisors and analysts have been warning us of ‘The Lesser Intelligence’ to be wary of bonds. All bonds have principal influenced by outside interest rates, usually determined by the Federal Reserve.  Rates also may be influenced by bond traders which often surprises the government officials who are of the mistaken opinion that they are always the ones in charge. The important thing to know is as interest rates increase principal decreases and as rates fall principal increases.

The fear by the Smarter Than Everyone set is that amateur investors have moved so much of their savings into bonds that when interest rates do go up most small investors won’t know what to do until they’ve lost a substantial sum of money.

Michael Santoli in the August 14th on-line Barrons wrote, ‘…in contrast to the purported economic malaise and acute risk aversion being foretold by teensy Treasury yields, the corporate bond market hasn't flinched at all.’

So far the apostles of fixed income doom have been wrong as bonds have enjoyed a remarkable year, outperforming most if not all major indices. The outperformance is due to the interest rates being forced lower and principal increasing. Yields on most domestic bonds is puny with the 10-year Treasury sporting a  2.68% current yield, down from 4% just this past spring. The fact that investors look more to perceived safety is evident as the dividend yield on the DJIA is at 2.65% which also offers an appreciation opportunity.

The lessons of 2008 are still very clear and lending, not investing, is where the small investor wants to be. Corporate America is taking advantage of it. IBM recently offered 3-year notes with a 1% coupon which was immediately snapped up.

The demand for bonds and fixed instruments is so aggressive that few individual issues are available for the average investor with short-term maturities and reasonably attractive rates of return unlike what someone could buy just 18 months earlier.

The Federal Reserve has signaled in plain Un-Greenspan-ish English that they plan on holding rates low for an ‘extended period’ of time. The experts think that this means rates may not be increased by the Federal Reserve at least through the spring of 2011. That doesn’t mean that the Federal Reserve can’t or won’t change their mind if conditions warrant.

What the Federal Reserve does plan on doing is something called quantitative easing or buying long-term 30-year Treasuries. This does not create more debt since the government is buying its own debt. It does provide for long-term rates to be lowered even more then they are now and create opportunities in mortgages and the loaning of monies by banks to businesses and individuals. The problem that sophisticated investors note is that the amount the government plans to buy of long term debt is not enough to encourage rates to fall. We will just have to wait and see.

Also today the markets are seeing more companies  with less than investment grade rating coming out to borrow money by issuing bonds. These are called high yield or junk bonds and they are filling a need for those investors looking to get a little extra return on their money. While there is a certain danger of default on these high yield bond issuers (about 10% with a historical mean of 5%) investors may want to set their sights on high yield bond funds where there is diversification and professional management rather then buying individual long-term issues.

Foreign bonds and emerging markets are also playing a significant role as investors scour the fixed income sector for any advantage to increase return. There are currency and political risks aplenty for those individual issues and it may be wise to only consider investing in mutual funds that specialize in those sectors.

As long as inflation remains a non-issue, unemployment a conundrum for the Administration and housing defaults as regular as an Activa junkie, investing in short-term maturity bond funds is just about the only game an investor can find.  That’s not to say it can’t or won’t change in a heartbeat.

If you have questions call Paul @ 877 783 7080 or write him at pstanley@westminsterfinancial.com. Share this blog with someone who cares about their money.