Bond Market Outlook: Stick to Shorter Term High Quality Investments

In contrast to a year ago, when - in the wake of the financial collapse - enticing yields were available on a wide range of bond investments, one is hard-pressed these days to find attractive opportunities in the fixed income markets. Cash earns next to nothing, creating a real dilemma for conservative savers, who should not expect relief any time soon, given the Fed's commitment to "exceptionally low rates for an extended period." Despite trillion dollar deficits, the 10-year Treasury yield remains artificially depressed at around 3.5%, due in part to unsustainable demand from (1) Federal Reserve monetization actions, and (2) U.S. banks able to borrow from the Fed at 0% and earn the spread on Treasuries.

In addition, the Chinese and other foreign central banks, despite their complaints about U.S. monetary and fiscal policies, continue to reinvest their trade surpluses in U.S. government bonds. Notwithstanding the very bleak longer-term outlook for government bonds, the U.S. for the time being is having no trouble selling its debt. Yields on riskier classes of debt have generally fallen to unattractive levels. Corporate bonds, which were a relative bargain at the start of the year, have recovered so much that in many instances absolute borrowing costs have fallen to their lowest levels in 15-20 years. Similarly, municipal bonds no longer offer the attractive yields and spreads they had early in the year. TIPs, while still a better value than traditional Treasuries, do not offer the same level of protection from fiscal profligacy as they did early in the year. "Break even" inflation rates, derived from nominal versus inflation protected bond yields, have moved closer to long term averages, with the 10 year rate now pricing in around 2% inflation, up from a low of 0.5% in January.

Despite the penalty of reduced current income flow, bond investors are well advised to stick to shorter-term high quality investments. One can never be certain about the timing, but a significant upward adjustment in bond market yields lies somewhere out there in the (probably not too distant) future. Federal Reserve market intervention and its zero percent interest rate policy has provided "cover" for the bond market, and that support appears likely to continue into early 2010, but investors needs to be mindful that bond market pricing does not reflect true market conditions.