Bond Investing: Inflation, Interest Rate Risk Weaken Corporate Bonds and TIPS

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To cushion the recession's financial blow and safeguard against shaky global markets, investors over the past few years retreated from stocks and poured billions of dollars into bonds.

From January 2008 through June 2010, outflows from equity funds totaled $232 billion, while inflows to bond funds hit a staggering $559 billion, according to the Investment Company Institute (ICI).

But as 2010's bull market continued climbing, and the U.S. Federal Reserve maintained its loose monetary policy, bonds' safe haven status faded in the second half of the year. Now analysts are warning investors to escape the investment in 2011, as inflation and interest rates are likely to rise and the bond market is headed for a downturn.

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"The worst investment is in U.S. long-term bonds," Marc Faber, who publishes the Gloom, Boom & Doom Report, told Bloomberg. "This is a suicidal investment."

Contributing Editor Martin Hutchinson forecast the prospect for bonds in 2011 in Money Morning's annual "Outlook" series, and warned those seeking greater safety to steer clear of bonds' pitfalls.

"[T]oday the forward-looking downside risk in bonds is in many cases much greater than it is in stocks," said Hutchinson. "Indeed, as interest rates rise back toward their historic norms, bonds now seem poised for a long-term bear market."

Investors are starting to listen. Bond funds saw the biggest withdrawals in more than two years in the week ended Dec. 15, with outflows of $8.6 billion, according to ICI.

Here Hutchinson addresses some lingering questions readers have asked about the state of the bond market and other related investments like Treasury Inflation Protected Securities (TIPS).

Question: Many analysts are now predicting a big drop in the bond market. I take it this refers to U.S. government debt, and I understand that as interest rates rise the price of bonds drops. But why does this affect the price of bond funds that are not U.S. government debt — corporate, foreign government and emerging markets, etc. – which have gone down, also. Can you explain how the correlation works?

- Sue W.

Martin Hutchinson: Traders price bond markets according to two factors. One is the risk-free yield for that maturity. The other is the "spread" above that yield required for the credit risk concerned. When the yield on 10-year Treasuries rises, (i.e. the price of existing bonds drops, increasing the yield of the bonds at the new lower price) by and large the yields on all other 10-year dollar bonds rise by an equivalent amount.

However, the ebb and flow of money in the markets not only affects Treasury yields, but investors' appetites for riskier bonds, as well. When money is scarce, as in 2008, the yield on Treasuries may actually decline, as investors "fly to quality," but the "spread" over Treasuries for riskier bonds zooms up. Thus, while investors in Treasuries may see a price gain in a credit crunch, investors in corporate and foreign government bonds may see a price decline. Investors in low-rated "junk" bonds will see their price collapse in a credit crisis, as markets worry that their issues will run out of cash and won't be able to raise money.

Currently, interest rates seem to be rising a bit, but we are not running into a credit crunch (at least, I don't think so). Hence, prices of Treasury bonds, high quality corporate/foreign bonds, and junk bonds will all likely decline by similar amounts.

If markets really start worrying about the U.S. budget deficit and debt, we may see Treasuries behave more like riskier bonds, while bonds of top-quality corporations, and maybe Germany, do better. But so far that hasn't happened

Q: I have substantial holdings in TIPS in my IRA; what are your thoughts about that?

- Cole

MH: Currently the prices of TIPS have been bid up, as they appear to provide both inflation protection and U.S. government safety.

The inflation protection, however, is a bit shaky, because TIPS are based on the U.S. consumer price index, which is "hedonically adjusted" to show inflation lower than we actually experience. Hence a yield below 1% on TIPS (as is the case out to 10 years currently) may actually represent a negative yield in real terms (after inflation is taken into account).

If money gets tighter, TIPS yields will rise and prices fall. If inflation rises, money will flow into TIPS and their yields will fall, making prices rise. In the long run, I expect TIPS yields to rise, causing their prices to fall, but my crystal ball is clouded on which way they will move in 2011.

Overall, my view is that TIPS are not as risk-free as they look, and that a modest holding (maybe 10-15% of the portfolio) of gold or silver, with the rest of the portfolio in a money market fund, may provide a better low-risk protection against a surge in inflation. Don't forget, if inflation takes off, the Fed will be forced to push up short-term interest rates, which will increase the yield on the money market fund.

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  1. Billy T | January 7, 2011

    What article said about TIPS is basically true, but not all have expense rising with CPI. Many retied no longer have kids to educate, don't need to buy clothes for going to work, and may own their home, etc. For them, their cost of living increases less than the CPI.

    Also as Social Security is adjusted by CPI (but only upwards) and there are an increasing percentage of voters collecting it. Thus, the Congress dare not let CPI get much below real inflation if they want to be re-elected. Also TIPS do mature with an INCREASED over face value paid.

  2. Ferdy Penna | January 12, 2011

    What US government safety.?
    USA is broke.!

  3. Dr SO Uremadu | January 18, 2011

    The prediction is likely to occur going by term structure of interest theory.

  4. Lee | July 26, 2011

    I really don't understand why world bonds should tank just because u.s. bonds do???

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