Yellowstone Financial, Inc.

Which Investment Bubble Should Concern You?

It’s been five long years, but the Dow set a new all-time high last week.  Having it make front page news for positive reasons has some investors concerned about a downturn.  While the contrarian in me appreciates the hand wringing, it’s unclear whether the stock market is overvalued.  What is apparent is that we are in the midst of a historic bond bubble.  We’ll talk about the bubbly evidence, how it could affect you, and what you should do to protect your portfolio.

The Case for a Bond Bubble.  Savers and retirees are well aware of historically low Treasury bond rates.  The five year Treasury bond pays 0.77 percent annual interest.  Ten year and thirty year bonds pay 1.9 and 3.1 percent interest respectively.  As recently as 2010 you could earn 4.7 percent on the 30 year Treasury while in 2000 the five year bond paid 6.5 percent.

So why do we care about bond rates from the (recent) past?  Remember that as interest rates rise, the value of bonds decrease.  It’s easy to understand why.  Let’s say you purchase a 30 year Treasury that pays 3.1 percent interest for $10,000.  In a year, imagine 30 year rates increase to 5 percent, which is not an unprecedented leap.  What happens to your bond?  Now no one wants your 3.1 percent bond and it may have to decrease in value by 30 percent to attract a buyer.

Now it’s true if you hold that bond for 29 more years, you will receive $10,000 back.  But you will have given up the higher prevailing rates for all that time.  Treasury bonds haven’t cornered the market on fixed income inflation as high quality corporates, high yield bonds, and munis have also seen significant price appreciation.

Other options.   Let’s consider alternatives that investors are using to fight low Treasury yields.  Long-term bonds pay higher interest rates than short-term bonds as we saw above.  While you will receive more income, if interest rates were to rise the long-term bonds would suffer a much more severe decline than short-term alternatives.

Another choice are so-called extended quality bonds, also known as high yield or junk bonds.  Here you are loaning money to companies with marginal creditworthiness.  While they pay higher yields, they don’t serve the important safety blanket function in your portfolio.  When the S&P 500 was down 37 percent in 2008, high yield bonds were down 26 percent as a category.  High dividend paying stocks are in the same boat – a good idea but not as a bond replacement.  You need bonds to counterbalance the panic you feel in market declines, not reinforce it.

Treasury Inflation Protected Securities (TIPS) pay interest plus inflation except now rates are negative 0.7 percent real yield for ten year bonds plus inflation.  Accepting a negative real yield is hard to swallow.

So what are we left with?  I Savings Bonds available through treasurydirect.gov are paying the rate of inflation right now, although you can only purchase $10,000 per year per person plus an additional $5,000 out of your tax refund.  Short-term corporate bond funds can give you a little better yield with manageable risk.  Some CDs such as those available at ally.com pay 1.6 percent for five years, with low early withdrawal penalties.  Finally, if you participate in a 401(k) or 403(b) plan, you may look at the stable value fund for better returns in a tax-deferred wrapper.

The bottom line is now is when you want to conserve your principal when it comes to your bond allocation.  You may earn paltry interest with these tactics above, but more than anything you are preserving your cash for when then interest rate environment improves.

David Gardner is a certified financial planner with a practice in Boulder County. He can be reached at yellowstonefinancial.com.