Fear-Based Bond Buying Creates Scary Scenarios

I mentioned that stocks, bonds, and cash all looked scary. Stocks because, well, they act like stocks. Cash is scary because of the abysmal rates of return it currently yields. I want to focus a bit more on bonds, because it seems that a lot of individual investors have been spending the last five years dumping their stocks and buying bonds.  I’m guessing some of you have done the same.

I want to begin this discussion by looking at Treasury Inflation Protected Securities (TIPs). These are U.S. government bonds that pay both a certain amount of interest and have a feature that effectively protects the bond holders from any inflation risk.  This is the ultimate “safe” investment. You 1) get some interest, 2) are protected from inflation, and 3) can stay out of that dangerous thing we call the stock market. What’s not to love?

Well, apparently a whole lot of people were struck with the love bug. Just like a hoard of shoppers the day after Thanksgiving, these securities bid higher and higher by people scrambling to get into something safe. The result:  the price of TIPs got so high that for most of last year, the effective real return on them, if held to maturity, was negative. Yep, people wanted safety so much that they were willing to trade a dollar today for less spending power in the future.

This same thing happened to normal U.S. Treasury Bonds during some of the darkest days of the Great Recession.

I'm sharing this to illustrate that bonds are very expensive relative to the returns you can reasonably expect from them. I'm not sure that this qualifies as a bubble, but it sure looks like one. If I said that about the stock market, you’d know you should be scared. The fact that I’m saying it about the bond market doesn’t change the fact that you should be scared.

Now, this isn’t to suggest you’ll go broke owning bonds. At least I hope not, as bonds are an important part of the portfolios I build for myself and my clients. What it does mean is that you shouldn’t look at the last 10, 20, or 30 years and use that as your measure of how bonds perform in general.

Why? Because for the last few decades, interest rates have been going down. Believe it or not, back in the early 80s, 10-year bank CDs paid well over 10% in interest. You may have noticed they don’t do that now.

Here’s the rub. Since rising interest rates make the value of any bonds you hold go down, you could see the value of your bonds go down faster than the interest that they pay. If interest rates don’t go up, then you’re stuck with the low rates of return current bonds are paying.

And if that’s not scary to someone who is keeping most of their money in the bond market, I don’t know what is.

This article was published under the title "Bonds very costly in the end" in the Wichita Falls Times Record News on January 20, 2013.