The Asset Class You Love to Hate But Hate to Love

Let’s talk a little bit about bonds.  In this day and age, bonds are not really all that sexy.  In fact, they’re boring.  Even more so than dividend paying stocks.  I mean, you get no capital appreciation due to growth of an enterprise, the payments are fixed, and they end once you reach maturity.  The way I feel about bonds is the way I feel about grapes freshly picked from the vine – nothing exciting right now but give it a few years to ferment and we can have ourselves a party.

Although I’m still learning about bond basics, you don’t have to look hard to realize that bond yields are at all time lows.  The 30 year note is trading for 2.56%, and the 10 year note is trading for 1.90%.  Check out the historical data:

yeah - not so great a time to be buying bonds

yeah – not so great a time to be buying bonds

If you’re looking for robust streams of income, bonds may not be the choice for you.  The problem is in the US, we are undergoing a massive demographic shift with baby boomers retiring in droves everyday.   A lot of these folks don’t have much to retire on at all (which is another post), but for those that do have money invested somewhere, standard asset allocation practices shove a good chuck of that money into investment-grade bonds (by investment grade, I’m talking about bonds that are rated as credit worthy by the big agencies – Standard and Poor’s, Moody’s, etc.).

This flow of money compounds the problem.  The Federal Reserve wants to keep interest rates low in order to keep stimulating the economy until they feel that it can stand on its own in a higher rate environment.  Add to the fact that more money is being put in retiree’s bond allocations and that’s going to drive prices up and yields down.

Another thing to consider here is that there are wayyy wayyy more bonds to invest in than plain vanilla US treasuries.  There are corporate bonds, municipal bonds, etc.  While these typically sport higher yields or tax advantages, a lot of fund managers out there are thirsty to juice of returns.  Instead of sticking with tried and true traditional bonds, many bond funds are starting to dabble in riskier securities that have a higher coupon rate.  Because the word “high yield” scares a lot of people off, a lot of these funds are called “non-traditional” bond funds.

Now, I’m not going to make a blanket statement and say that these funds are a bad buy, because I don’t really know.  I’m sure there are some that are better than others.  The problem is, I don’t think that most people should venture off beyond the world of bonds that are considered investment grade.  What’s that famous quote?  More money has been lost reaching for yield than has been taken at the barrel of a gun.  Be careful where you put your money and always look at risk-adjusted rates of return.

I’m certainly not going to write bonds off forever, but right now, they just don’t seem like much of a bargain at all (on a basket basis – I’m sure there are deals out there but my level of knowledge is not sophisticated enough yet to spot them).  Look at the treasury yields back in the late 70’s and early 80’s.  The yields were over 10% – on government debt!  Part of me wishes I was around in those times.  There was inflation and stagflation going on, but if you knew the historical data that inflation over the long term in this country runs at about 4% per year, you could have made a relatively safe projection that the high interest rates of the day would not last and bought a bunch of high yielding Treasury debt.

Alas, I digress.  It is not wise to dwell too long on missed opportunities, especially if they are opportunities I couldn’t actually take advantage of because I wasn’t born yet!  My point is to say that these days, a lot of financial people don’t talk about fixed income because the yields are so darn low right now.  However, it would be wise to look at history and remember that financial markets come in cycles – no asset class stays at any given level forever.  Hopefully one day, I’ll be able to rationally add bonds to my family’s portfolio.  Realistically though, I doubt that will happen for a few decades.  After all, I tend to prefer dividends as a source of passive income because they are tied to business profits, which rise exponentially over time for a successful enterprise.