Bonds: Buy, Sell Or Hold?

Includes: LQD, MYD, TLT, VGM
by: Robert Kessler

US interest rates are likely to rise over the next year and that should limit performance of high credit quality bonds as well as municipal bonds. With the European debt crisis coming back to haunt us occasionally and the Federal Reserve still committed to their bond buy back program until the end of June, Treasury yields may be stuck in a range over the short run.

Investors have flocked to bond funds of all varieties to pick up yield but may discover eventually that when yields go up, bond prices go down. An investment grade bond fund ETF that has had a great run these past few years but is now vulnerable over a medium term horizon would be the one offered by IShares (NYSEARCA:LQD), and also from IShares but strictly dedicated to long term Treasuries and even more exposed to rising interest rates, would be their 20+ year Treasury Bond Fund (NYSEARCA:TLT). Leveraged Municipal Closed End Funds (LMCEFs) such as those offered by Invesco (NYSE:VGM), BlackRock (NYSE:MYD) and many others that offer investors enticing coupons in our currently ultra low interest rate environment by using debt will eventually suffer as well. Over the longer term, a 2% 10 year yield after taxes and inflation ends up being negative and that is not sustainable nor desirable for investors, especially when the US economy appears to be growing around 2-3% per year. Added to that is the historical tendency of interest rates to be higher in times when countries accumulate too much debt.

The Fed wants to get to a point when stimulus is not required to support economic growth as well as financial market stability. Tuesday three Federal Reserve governors expressed the lack of need for any more quantitative easing measures, one of whom has openly dissented at recent FOMC meetings.

Treasuries have long been considered a very uninteresting investment due to their relative low yields which some people think of as their return. The reality is that bond returns come from price appreciation as well and as interest rates have been falling for most of the past 30 years, Treasuries have been one of the best performing assets over almost any recent historical time period you observe. That is likely to change, or at least your risk/reward is not nearly as favorable considering that yields are hovering around the lowest they have been in over 50 years. High grade corporate bonds, debt of companies with relatively high credit ratings and generally safer from a credit quality perspective than high yield bonds, are vulnerable as well since they trade with a certain spread over Treasuries and that spread has been tightening over the past few years to a level that offers more risk than reward going forward.

High yield bonds may do relatively better as they will be less interest rate sensitive and have a higher coupon to protect investors from price erosion. If you sell your high grade bonds, what do you buy? Equities still appear to be cheap on a historical price/earnings ratio basis despite having provided stellar returns this past 6 months already. Over the past 15 years stocks have generally provided returns lower than the historical average so there is room for some catch up. I imagine most people buy bonds because they don't like the volatility of equities but neither do they like keeping their money in the bank or a money market mutual fund that offers 0% or only slightly better. That being said, past lessons have taught us that 0% is better than negative returns so don't fall for the temporary satisfaction of a little extra yield and be patient for a better entry point.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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