Bonds have higher yields then stocks. Bond funds have higher yields then stock funds. This means more current income for you. Bonds and bond funds are (generally) safer then stocks and stock funds.  They fluctuate less in value. That’s good, too. So what’s wrong with this picture? Bonds are fixed income securities. Their income doesn’t grow, nor does their principal value. As a matter of fact, the real value of their principal declines over time due to inflation. 

 

Now, before you jump all over me, yes, there are inflation-adjusted Treasury securities that increase in value with inflation and floating-rate bank loan funds whose yield should increase if interest rates go up. Also, you can realize a (usually modest) gain in principal value if you buy a bond at less then its face value and hold it until maturity.

 

And, there are some managers who through astute analysis, forecasting and trading, add value and outperform a simple buy and hold strategy. However, superior relative performance becomes harder to achieve as you go up in quality, think: High yield (“junk bonds”) at one end of the scale and U.S. Treasuries at the other.  The same is true for maturities.  There’s not much a manager can do to create relative value with short term bonds. Value can be created by correctly forecasting (good luck!) interest rates and buying, or selling, long term bonds.

 

Bond funds have their place in your portfolio. It’s always wise to have a cushion for unforeseen expenses or just to be able to take advantage of an opportunity in the market or elsewhere. If you’re going to need cash at a certain time for events such as buying a house, college education, or the like, having the safety and certainty of a bond fund is a smart investment. Caveat: if you need funds at a not too distant date don’t speculate with a risky bond fund, you’ll be unpleasantly surprised with its volatility.

 

I fear that too many investors put too much money in bond funds and too soon in their investing careers. The income may be reassuring, or seductive, but the limited appreciation and the inflation purchasing power risk must be considered. There’s one more reason not to put too much capital in bond funds. Come back on Wednesday and I’ll tell you what it is.

Bill Gross, the founder of Pimco, is the godfather of savvy bond investors and, if you’re looking for a good bond fund Pimco should be on your list.  He wrote a thought provoking piece in the May 28^th issue of FORTUNE: How to Sleep Well at Night. Bill says that bonds are less volatile than stocks, provide a higher and steadier source of income, and allow you to sleep better at night. (That’s true, although I’m going to argue in coming weeks that good performing dividend paying stocks will provide a higher level of income than bonds over time, but that’s another story.)

 

Bill admits U.S. Treasuries, which are currently yielding under 5%, may be 50 basis points (.5%) overvalued. He also acknowledges that you can get just as good returns at the bank (I’d say in money market funds). 

 

Why buy bonds? International recycling of dollars will drive yields lower, says Bill. Demand will drive up the price. Wow! The more we buy overseas, the more money foreigners will invest in U.S. Treasures. We should all go out and buy Japanese and German SUVs and use them for our daily commute. Maybe buy some French wine and a new Korean made stereo system while we’re at it. The more we spend on foreign goods, the greater the demand for U.S. Treasuries. (By the way, if Treasures have lower yields that’s good for the stock market, too! Part of the stock value equation is the Treasury yield plus an imputed risk, or rate of return, so if Treasury yields decline, the required return for stocks declines and the stock market goes up.)

 

Sounds too good to be true, Bill. It seems to me that supply and demand works the other way. The more dollars foreigners hold, the higher return they’ll demand to hold even more dollars/Treasury bonds. I also worry that perhaps a government, such as China, might hold all those Treasuries over our head at some point seeking something in return. (I’m happy to be financially independent of my parents, I don’t want to become financially dependent on China.)  

 

If Bill’s right that long term Treasuries are overvalued (who am I to argue with him?) and if I’m right about how supply and demand works, you might be right to hold only short term bond funds.

Bond yields are supposed to increase with the length of time until the bond matures and you get your principal back. (When I talk about bonds I’m really mean any fixed income investment: bonds, bills, notes, CDs, and so on.) A basic, maybe the basic principle of investing is the risk/reward trade-off. You have to take risk to earn a return. The corollary is also true. The more risk you take, you greater should be your expected reward (return).

 

The risk/return trade-off means there should be a positive relationship between the expected return and the maturity of a bond. The longer to maturity, the higher the yield. Why? Because the longer until maturity, the greater the risk. Risks include inflation reducing the value of the bond, rising interest rates, having to sell the bond at a loss prior to maturity, and, except for US Treasuries, default by the issuer.  

 

The yield curve (return vs. maturity) should be an upward sloping line – yields rise as maturity increases. This is the normal state of the bond market. But look what’s happening right now. The Treasury curve is inverted (I’ll explain that in a minute) and the yield on other fixed income securities is almost flat. Something’s wrong with the bond markets.

 

The Treasury market is upside down. For example, the yield on one year Treasuries is 4.94% and the yield on five year Treasuries is 4.54%. You’re losing 40 basis points of return annually for taking 4 years additional risk. (That’s the inverted yield curve.) Now, you might be willing to take that bet if you thought inflation or interest rates would going to move significantly lower over the next five years but do you really that’s going to happen?   I thought not. One year CDs yield 5.05%, 10 year CDs yield 5.75%. That’s almost a flat curve (no pun intended). Do 70 basis points (.7%) really compensate you for 10 year’s illiquidity and inflation/interest rate risk? What’s the penalty for early withdraw on you CD?

 

Inverted yield curves don’t last for long and are usually an indicator of a peaking/declining economy. Mutual fund investors should be wary. It’s a good time to stay short-term in your bond portfolio and a good time to be cautious about the stock market (especially with the Dow over 13,000). Liquidity is a smart response to an inverted yield curve.