Bond fund sales around the world are continuing at a record pace with $350 billion in net inflows during the first half of 2012. This continues the pace of the prior two years as investors continue to seek the safety of bond funds. Taxable bond assets have more than doubled since the end of 2008, increasing to $2.1 trillion from $1 trillion. Combining these massive fund flows and a very accommodative Federal Reserve has resulted in bond yields collapsing to levels last seen over 50 years ago. The current yield on a 10- year U.S. Treasury bond is now 1.6%. In looking at historical precedent, the period that most closely mirrors 2012 is the 1940s. Throughout the Great Depression of 1929-1933, Treasury bond yields declined as economic growth and inflation turned negative. Under the New Deal in the 1930s, the U.S. Treasury issued new bonds at low interest rates to fund public works and America's preparation for and entry into World War II.
The 10-year U.S. Treasury yield was at 3.2% at the start of 1930, but declined to 2.2% by the end of the decade. Interest plus gains in price appreciation resulted in a total return of 4.4%. Over the decade of the 1940s, bond yields rose as inflation picked up, averaging 5.1% while 10-year Treasury yields averaged only 2.3%. Upward movement in yields has a hefty impact on bond prices. As bond yields first rise in a low interest rate environment, capital losses are more pronounced as lower interest payments only partially offset the capital losses. As yields increase to greater amounts, higher annual interest payments are more successful in offsetting the price declines. As interest rates increased especially towards the end of the decade, total return was muted. The total annualized return during the 1940s was a mere 1.8%, a quote remarkably below even the average rate of inflation during the 1940s.
Given that government bond yields today are at historical lows, the opportunity for further price appreciation is minimal. More likely, the collection of interest payments will provide most, if not all, of market returns. Much like the decade of the 1940s, total returns from bonds will most likely be subdued as either market interest rates remain constant or interest rates trend upwards. Most certainly investors cannot expect an average return of 5.7% that intermediate Treasury bonds have delivered over the long term (1930-2010). A 1-3% total return over the ensuing decade is most probable. Of course, the real return after inflation could easily duplicate the 1940s, resulting in substantial loss of purchasing power. Most individual investors and pension plans have a substantial portion of their assets in bonds, especially of the government sort. Investors today must expect either a substantial decline in interest rates from the current historic lows, or that the stock portion of their accounts will make up the difference.
For the fixed income investor, producing a return above the rate of inflation will be very difficult in the proceeding decade. An investor could reach out for yield by lengthening maturity. But in doing so, an investors would also take on the enhanced risk of price losses as extended maturity bonds maintain greater price sensitivity to upward moves in interest rates. If you are to invest in any bond that maintains a maturity date of 5 years or longer, it is imperative to own individual bonds with a definitive maturity date. The advantage is an individual bond always has a set maturity date and upon maturity it will be redeemed at face value, no matter the interest rate environment at maturity. Although your individual bond will move down in price if interest rates increase over the length of the maturity, upon redemption your original face value will be returned at par. You may also mitigate price risk by purchasing interest rate hedges, which over time will offset price depreciation. An investor can utilize interest rate hedges through ETF securities like the ProShares UltraShort 20+ Year Treasury (NYSEARCA:TBT) fund. Another strategy for increasing potential yield is purchasing individual corporate bonds, which pay a slight premium to Treasury bonds due primarily to credit and liquidity risk. You currently receive a slight premium of a half percent (AAA rated) to just over 1 percent (A rated) for higher rated corporate debt. BBB rated debt is still considered investment grade and yields a slightly higher premium than A rated bonds. This spread over government bonds varies over time (chart).
There are several caveats on purchasing individual corporate bonds. First, you must have enough dollars to diversify among a large swath of issuers. Second, trading on corporate bonds is a fraction of corporate shares. Find a broker who is knowledgeable and will offer you good pricing on purchases despite the inherent low liquidity in the marketplace. Third, spread out your purchases over time, adding to corporates when spreads over Treasury bonds are high (i.e. 2008).
Although bond returns should remain very low by historical standards over the ensuing five to 10 years, you can protect your principal and enhance return. You can accomplish this by having a preference for individual bonds over funds, adding to corporate bonds when spreads are high, and maintaining small positions in interest rate hedges to offset inflation risk.
Disclosure: I am long TBT. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.