In the good old days, investors seeking income at little risk knew just what to do: buy bonds.
For decades, it worked like a charm, and investors also scored capital gains as interest rates declined.
Then, record low interest rates reduced the income return from bonds and made them very risky. Suddenly, you had to invest in long-term bonds to get a reasonable income, even though going long increased the risk of capital losses.
In the past few months, though, yields have backed up, making Treasuries somewhat more attractive.
So the magic question is: At what level do bonds become a “Buy” again?
A Matter of Timing
The 10-Year Treasury bond yield, which fell to 1.67% at the end of January and 1.83% in mid-April, had backed up to 2.48% by the middle of last week. In addition, the 10-Year German bund yield had briefly risen from as low as 0.08% in mid-April to over 1%.
Interestingly, though, the Bloomberg High-Yield Bond Index (BUHY) is at almost exactly the same level as in mid-April, which is up 5% from late December. It’s currently yielding 6.77%.
That certainly suggests it isn’t time to get back into bonds yet. The divergence between Treasuries (nominally risk-free) and junk bonds – with the latter outperforming – suggests that the move in Treasuries is merely a correction to the overblown fears of deflation that were prevalent earlier this year.
There are two factors in operation here. First, inflation is beginning to reappear, with the producer price index up 0.5% in June. If those signs continue, bond prices will decline substantially, both because bond yields must adjust to reflect higher inflation and because higher inflation will make the Fed more likely to raise short-term interest rates.
If inflation resumes properly, you’d have to look for an approximate yield of inflation plus 2% before bonds became a “Buy” again. That’s a moving target (and a receding one). Thus, if inflation gets a hold, bonds are a bad deal at anything close to current levels.
However, there’s an alternate factor at work. The extended period of ultra-low interest rates has allowed vast numbers of un-creditworthy borrowers to raise money from the junk bond markets. Either a rise in interest rates or a recession will push those borrowers into bankruptcy. That’s clearly not happening now, or the junk bond market wouldn’t be outperforming the Treasury bond market. But if the economy were to decline before inflation reappears in force, we can expect to see a credit crunch, with junk bond prices falling hard.
Are There Bond Alternatives?
At that point, there would be a “flight to quality” in bond markets, which would push Treasury bond prices up. What’s more, any tendency for the Fed to raise interest rates will evaporate, and more money will be pumped into the system. Treasury bond prices will then inflate further.
Given these strong forces, long-term Treasury bonds are certainly not a risk-free investment (as they’re often advertised). Even if you believe a credit crunch is likely to occur before significant inflation takes hold, buying Treasuries at these levels is a gamble.
The risk can be reduced by buying Treasury Inflation Protected Securities (TIPS), but at present, 10-year TIPS yield only 0.55%. That’s up from a low of minus 0.02% in mid-April, but it’s still not a bargain.
If real yields return to their historic average of around 2%, that will produce a price decline of some 13% on a $100 investment – which is considerably more than the $5.50 you’d get in interest over 10 years. So it’s still not a very good deal.
To invest in Treasury bonds, you need to know that inflation is stable at around the Fed’s target of 2% and that Treasury bond yields are sufficiently higher than the inflation rate to make them worth investing in. To me, that suggests a minimum Treasury bond yield of about 4% before you should invest.
You can then invest in prime corporate bonds if you want more yield – in those circumstances, they would probably yield around 5% to 5.5%. I would probably avoid junk bonds even then, unless there’s been a major shakeout. At some point, the carnage will be so bad that the sector will be devastated, and the survivors will be excellent bargains.
In the meantime, it’s best to stick to dividend stocks. If you choose solid companies, they’re less likely to cause trouble. And if you want to profit from the coming rise in bond yields, there’s always the ProShares UltraShort 20+ Year Treasury (ARCA:TBT), which will provide a nice profit on any sharp run-up in yields.