The perception has long been that investing in bonds is a safe way to generate investment income without much risk.  Today, numerous articles and letters to the editors of financial publications are sounding the alarm bells about the risks of investing in bonds.  This issue will address those warnings and explain a prudent approach to bond investing in the current market.

Is there a bond bubble?

In an August 18, 2010, letter to the editor at The Wall Street Journal, Wharton School finance professor Jeremy Siegel refers to the current state of the investment markets as the Great American Bond Bubble. Based on the historically low rates currently available for investing in U.S. Treasury bonds, he proffers that an investor may be better served simply by investing in high-dividend paying stocks. While Professor Siegel is able to win column ink in TheWall Street Journal due to his position at a prestigious school, it should have been disclosed that he and his co-author serve as board members and research heads at Wisdom Tree. Wisdom Tree is a firm that sells funds consisting of high-dividend paying stocks. Instead, USA Today and other publications increased the exposure to Professor Siegel’s comments by printing articles that picked up on his “Bond Bubble” forecast.

Rather than taking The Wall Street Journal to task for failing to disclose the conflict of interest, we will explain how Treasury Bonds cannot ever be the center of an investment bubble. A typical investment bubble is formed when prices escalate to great heights and the investor is at risk of losing much or all of their investment if the direction of the market turns against them. In the 17th century, tulips in Holland represented one of the first documented investment bubbles; the technology stock crash earlier this century is a more recent example. Unlike tulips or tech stocks without any earnings, U.S. Treasury security investing relies on confidence in the ability of the U.S. government to repay the notes. Only if the U.S. government defaults on its direct obligations would an investor risk losing their principal, assuming they hold their bonds until maturity. (The maturity date is the date on which the principal is repaid to the bond holder.) Therefore, while new investors in Treasury securities may be locking in very low returns, they do not face the risks associated with investing in bubbles. In the tulip and tech stock crashes, there was no safe way to exit the investments when no one wanted to own them.

U.S. Treasury bills, bonds, and notes are known as “risk-free” assets because the U.S. Government has never defaulted on them. In fact, they are used as the measuring stick for the relative investment risk of all other investments. In simplest terms, you would never want to own an investment with a lower expected return than a U.S. Treasury security with the same investment time frame because you would be taking greater risk for a lower expected return.

What are the risks of owning bonds?

The next issue to address is why you would want to own U.S. Treasury securities if their expected returns are so low. The answer is safety. Any time there is uncertainty in the investment markets or global tensions are rising, demand for the safest investments increases. During the bleakest days of the recent recession, and more recently in April when it looked like Greece was about to join Iceland in declaring sovereign bankruptcy, there was a tremendous demand for Treasury securities which increased prices and decreased yields on the bonds. (The yield is the amount of income the bond pays.) If you are buying Treasuries at the same time that demand is peaking, you will be accepting a very low return for holding your investment until maturity. If you need to sell your bond before maturity, and market interest rates have risen from the date of your purchase, you will lose a portion of your principal.

Holding other variables constant, bonds with the highest risk of default will have the highest yields. Treasury securities are at the other end of the spectrum. The difficulty evaluating the credit worthiness of different bond issues has been headline fodder in recent years. The major rating agencies were criticized for giving some bonds the highest ratings only to have those same bonds going into default just months later. Conflicts of interest were seen as a major problem with the ratings process; but even without the conflicts, it can be difficult to predict the repayment ability of an issuer with any degree of certainty. The following chart illustrates the relative riskiness of different types of bonds commonly held by investors:

As can be seen in the chart, the range of municipal bond credit quality runs the gamut. Some municipal bonds are backed by Treasury securities (known as pre-refunded) and have virtually no credit risk. Other municipal bonds are backed by revenue streams that can come under significant pressure. Therefore, when investing in bonds of any type, and especially municipal bonds, it is essential to invest with a bond manager who continually performs due diligence on all bonds held in the portfolio and others that are under consideration for purchase.

Don’t bonds generate attractive rates of income?

In addition to evaluating the credit quality of a bond, it is also important to consider the time to maturity of the bonds being purchased. Typically, the shorter the time to maturity, the lower the yield. Conversely, the longer the time to maturity, the higher the yield. In periods of deflation, when goods and services are expected to cost less in the future than they do today, the yield curve as it is known can become inverted with shorter maturity bonds offering higher yields than longer term bonds.

One topic that has been receiving attention recently has been the low levels of yield across the yield curve. The government sets the rates of return on the shortest end of the curve through different policy measures, and the market sets the rates for the intermediate and longer term periods. While the government can actively buy back certain longer-term securities to influence the yields along the curve, the market ultimately determines the rates.

As the chart below illustrates, yields have been falling for the last decade, especially the yields at the shortest end of the yield curve. The chart also shows that the curve has steepened.

That is, the yield on the short end of the curve is now much less than it is on the longer end of the curve. At the start of the decade, the yield curve was flat and slightly declining. At that time, the stock market was performing very well and investors had to be incented with high yields to pull even short-term money out of the stock market to buy bonds.

The good news for investors who have owned bonds over the last decade is that the falling rate environment led to capital appreciation in addition to the yield generated from bond investing. For investors who sold bonds while rates were declining, they locked in profits. The challenge for investors today is that rates do not have much room to fall and are in fact at near historic lows across the yield curve. As rates rise, investors will need to hold bonds until maturity to avoid capital losses or work with skilled bond managers who may not hold the bonds to maturity but will attempt to add value through credit (risk) analysis and yield curve positioning.

Just like it is impossible to accurately time investing in the stock market so as to be in the market on the good days and out of the market on bad days, attempting to forecast future interest rates and future shapes of the yield curve is perilous. Many top bond managers expect the slow economic recovery to keep the longer-end (10-30 years) of the yield curve relatively stable, while they expect the shorter-end (less than 3 years) to rise modestly when the interest rate increases come. Will they be right? Only time will tell. In recent years, the Federal Reserve has been giving the market more time to react to their planned future intentions for setting short term interest rates. By providing this guidance, the bond market can react in a more orderly fashion, allowing bond portfolios to be adjusted without tremendous shocks to the principal value of the portfolios. On August 10th, the Federal Reserve said “inflation is likely to be subdued for some time.” This recent message suggests that it will be many months before short-term interest rates rise as the Federal Reserve will wait to raise rates until they believe inflation is a threat.

How should you invest in bonds in today’s market?

The risk today for investors buying bonds is that they may be locking in yields that are insufficient to meet their total return needs with little hope for falling rates to provide capital gain opportunities. Some people are addressing this risk by holding cash today with the expectation of buying bonds at a later date, after the rates have risen. This strategy sacrifices the opportunity to capture the currently available yields even if they are at historically low levels. The fact is that yields may be low for several more years. Also, there are no guarantees that when short term rates rise, investors will see any movement in longer-term rates. Market timing is a dangerous strategy. Instead, investors should seek yield from different types of bonds and spread their risks over a greater variety of issuers. This strategy provides for greater current income and the added diversification reduces the default risk of any single issuer and the performance risks of any one segment of the bond market.

Municipal bonds are especially attractive in advance of the rise in personal income taxes that takes effect on January 1, 2011. As illustrated above, municipal bonds exist in all different credit qualities and maturities. Having exposure to them provides federally tax-free income and in some instances income that is also free from state income taxes. On an after-tax basis, municipal bonds provide better returns for most clients than taxable bonds of similar credit quality. (Taxable bonds include Treasury bonds, agency bonds, corporate bonds, floating rate debt and high-yield bonds). The increased demand for municipal bonds that has always followed increases in income tax rates should provide some downside protection for holders of municipal bonds. The demand for municipal bonds is expected to be strong for many years as the demographic trends show increasing numbers of retirees who will need income to support their lifestyles.

The bond investing experts are shying away from Treasuries, including Treasury Inflation Protected Securities (TIPS). Instead, since they expect the economy to continue its slow recovery, they are buying corporate bonds and other riskier bonds and increasing the maturities of the bonds in their portfolios. Dan Fuss and Kathleen Gaffney at Loomis Sayles are not concerned about near term inflation. They expect interest rates to “remain low for longer than expected.” Bill Gross of PIMCO cites the global demographic trends in his expectations for a slow growth period for the next five to ten years. PIMCO has been buying bonds with longer maturities in an effort to generate more income during a period when they feel comfortable that rates are not likely to rise. In summary, the experts do not think the economy will get much worse, but they caution that the recovery will take several more years before growth returns to historical rates.

A well diversified bond portfolio with exposure to a variety of different issuers and a variety of different maturities is the best way to capture some yield while minimizing the risks. During the final four months of 2010, we will seek to add more bond diversification and greater municipal bond exposure in client portfolios. Unfortunately, the slower growth economic environment which we are in requires us to accept lower expected returns for our portfolios. While we can take some comfort that the prospects for near-term inflation are low, Oak Wealth Advisors will not forget the negative impact that inflation can have on a portfolio. The importance of tax-efficiency in the portfolio is heightened by the rising income tax rates that are coming over the next three years. Oak Wealth Advisors will continue to keep its focus on helping clients retain as much return as possible from their investments after accounting for fees and income taxes.

This update is intended for the use of Oak Wealth Advisors LLC clients. This update should not be viewed as personalized investment or financial planning advice from Oak Wealth Advisors LLC. To the extent that a reader has any questions regarding the applicability of any specific issue discussed above to their individual situation, they are encouraged to consult Oak Wealth Advisors LLC. Past performance does not guarantee future results and all investments should be scrutinized before being implemented in a portfolio.