A Bond Investment Strategy For the New Year

For those seeking greater safety, bonds will be the wrong place to look in 2011.

To understand why, we need to look back more than 25 years - to a time when economic conditions were very different than they are today.

Time Warp

The year is 1982. To keep things simple, let's assume we're in a simplified, hypothetical world in which investors have two choices:

• Stocks.
• And U.S. Treasury bonds.

Unlike our simple hypothetical example, the real economy of 1982 was harsh - and complicated.

Then - as now - the United States was in a deep recession. In November of that year, in fact, the unemployment rate actually hit 10.8%.

There are differences, however. Whereas today the U.S. stock market is fairly close to its all-time high, in 1982 it had been dropping in real terms for the preceding 16 years, and had lost almost three quarters of its value.

Then there's gold. In 1982, gold prices were falling - not rising to record after record, which is the case today. Inflation, too, was falling - and sharply: From 8.9% in 1981 to 3.4% in 1982.

Finally, short-term interest rates were extremely high, far above the level of inflation, though the average for 1982 at 12.24% was well below the 1981 average of 16.39%.

Just as in the 25 years from 1982 you could do better in Treasury bonds than in stocks if you bought long enough maturities (preferably 30-year zero-coupon "strips") so the downside risk in bond investment today is in many cases greater than that in equities.

With inflation declining and short-term interest rates extremely high, the chance for a bond-market rally was excellent. The 30-year Treasury bond yield - which had peaked at 15.32% in September 1981 and was still at 14.30% in June 1982 - had by December 1982 fallen to 10.54%.

And a rally was what investors got. In fact, in the 25 years that followed, the investors in our simplified example who bought Treasury bonds (especially long-maturity bonds such as 30-year zero-coupon "strips") trounced those who chose stocks.

A Forward Look

Fast forward to 2010 - where the situation is almost completely opposite the one that faced investors back in 1982.

The U.S. Federal Reserve has been keeping monetary policy extremely loose for several years (and rather too loose since 1995, I would argue). Inflation is low, but is showing every sign of rising in the years ahead. Short-term interest rates are below the rate of inflation, and will become more so if inflation rises.

Just as in the 25 years from 1982 investors fared better in Treasury bonds than in stocks (again, assuming that they bought long enough maturities), today the forward-looking downside risk in bonds is in many cases much greater than it is in stocks. Indeed, as interest rates rise back toward their historic norms, bonds now seem poised for a long-term bear market.

Naturally, you won't lose much in short-term bonds - but you won't gain much, either.

The two-year Treasury note yields 0.62%, below even the modest rate of inflation - so in real terms, even over the short two-year life of the bond, you will lose money in real terms.

Investing in long-term bonds is much riskier.

Ten-year Treasuries today yield 3.29%. If, in two years, eight-year Treasuries are yielding a mere 5%, you will lose 11% on your investment, plus the effect of inflation.

On a 30-year bond, if rates go from the current 4.4% to 6% in two years, your principal loss would be 22%. Needless to say, if inflation really took off and interest rates went back towards 1982 levels, your principal losses would be much larger.

To make up for the low yields on Treasuries, many investors have taken to buying junk bonds. Issue volume in 2010 is above $300 billion, compared with the previous peak of $162 billion, which was established in 2006.

With junk bonds, the higher interest rate protects you against inflation, but not against a general rise in interest rates. What's more, since junk bonds are mostly issued by overleveraged companies, a general rise in interest rates, even if the economy stays sound, will be accompanied by a surge in defaults as cash flow calculations made on the basis of lower interest rates prove to be overly optimistic.

Thus, by investing in junk bonds, your risk from a rise in interest rates is doubled. Not only will you suffer a loss through a decline in the principal value of the bond, but you also might suffer a bond default.

There are two solutions to this problem. First, if you are seeking the stable yield that bonds offer, you should consider investing in stocks with high dividend yields, taking care to make sure the companies themselves are not overleveraged.

Share prices are much more dependent on the earnings prospects of the underlying company than directly on interest rates, so you are less likely to suffer a major loss of principal simply from an interest rate rise. What's more, dividend yields on shares are often considerably higher than on any but the riskiest bonds - you can find 7% or even 8% yields quite easily, even in today's markets.

Second, embrace a strategy that will enable you to profit from an increase in yields. Invest in an exchange-traded fund that is inversely linked to Treasury bond prices. One such fund is the ProShares UltraShort 20+ year Treasury Bond ETF (NYSE: TBT).

This ETF will rise in price as long-term Treasury bond prices decline. The one problem is that itachieves its position by rebalancing a Treasury bond futures position daily, so if held too long can accumulate "tracking error" causing holders to lose money. However, for a holding in 2011, it offers considerable attractions.

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