Investing in Bonds: Three Steps to Smarter Bond Investing
by Alexander Green, Investment U Chief Investment Strategist
Monday, March 5, 2012: Issue #1722
At our Oxford Club Chairman’s Circle conference at The Ritz-Carlton in Naples last week, I noted a decided optimism about the outlook for the bond market. This enthusiasm is almost certainly misplaced.
We’re at the tail end of the biggest 30-year rally in bonds the nation has ever seen. Recall that three decades ago, Fed Chairman Paul Volcker pushed the prime rate all the way up to 21.5% to squelch inflation. Long-term Treasury yields reached 16%. But from that pinnacle, long-term yields have plummeted to around 3% today. Bond prices have soared accordingly.
It isn’t just unlikely that today’s bond buyers will see annual double-digit returns going forward, it’s mathematically impossible. And yet I sense that many fixed-income investors don’t understand this.
It’s not unusual to meet an investor who has plunked money in a bond fund because “its long-term track record is excellent.” They don’t seem to realize that it’s also irrelevant. Never has the old saw, “Past returns are no guarantee of future results,” been more apropos.
This doesn’t mean you should avoid bonds altogether, of course. But if you’re going to buy bonds, now more than ever you need to be smart about it. Here’s what you should do:
Some fixed-income investors tell me they feel safe for now since Bernanke has pledged to keep interest rates low through 2014. Think again. The Fed has only announced its intention to keep rates low. (Future economic conditions could quickly change that.) The Fed is also keeping long-term bond yields artificially low by buying these instruments to goose the economy.
Inflation could tick up. The Fed could raise rates and/or quit buying long-term Treasuries. In the end, the Federal Reserve sets short-term interest rates, but not bond yields and prices.
Know this. Understand it. And act accordingly. Bond investors today should be in a defensive posture, capturing higher yields than what’s available in cash instruments, but prepared for that point in the future when bond yields will rise and prices will fall.