Recently, I wrote an article entitled "Your Retirement Investments: Stocks Vs. Bonds." In response to this article, the concern was raised as to whether bonds bought or held today can be profitable in the longer-term.
The issues with buying or holding bonds today are well known. In the U.S., for instance, we now have QE3, which follows QE2 and QE1. These QE (quantitative easing) programs are unusual steps taken by the Federal Reserve to additionally influence interest rates downward. They have a downward influence on interest rates beyond that which is achieved by having the Federal Funds Target Rate at 0.00-0.25%, where it has been since 12/16/08. Also, there is heightened degree of fear in the marketplace due to the Eurozone debt crisis and U.S. fiscal cliff concerns; so more money wants to be in U.S. Treasuries and certain U.S. mortgage-backed securities than is usual. The QE programs have purchased or will purchase Treasuries and/or mortgage-backed securities, but the extremely low Federal Funds Target Rate and QE programs have influenced the yields of other U.S. fixed-income investments, such as municipal and corporate bonds, downward as well.
As of 9/21/12, the end effect is:
iShares Barclays Aggregate Bond Fund
iShares Barclays TIPS Bond Fund
iShares Barclays 20+ Year Treasury Bond Fund
iShares Barclays MBS Bond Fund
Vanguard Intermediate-Term Corporate Bond ETF
iShares iBoxx $ Investment Grade Corporate Bond Fund
Vanguard Long-Term Corporate Bond ETF
iShares iBoxx $ High Yield Corporate Bond Fund
SPDR Barclays Capital High Yield Bond ETF
SPDR Nuveen Barclays Capital Municipal Bond ETF
Market Vectors® Long Municipal Index ETF
PowerShares Insured National Municipal Bond Portfolio
1 From Morningstar. In my experience, in the current environment, 12-month yields tend to be a little higher than what the actual yield is; but 12-month yields offer a better comparison between bond ETFs than the other quoted yields do.
2 You may not need to pay U.S. income tax on these distributions.
JNK and HYG's yields look relatively attractive, but you are basically just receiving a higher yield in exchange for a greater default rate [and related loss of principal] than you would have in an investment-grade corporate bond fund holding bonds of similar maturities. For longer-term investors, I think JNK and HYG are poor choices. I suspect they are over-priced relative to like investment-grade corporate bond funds due to a lot of limited-knowledge retail investors chasing higher yields in recent years. Also, if you are older and the investment is to be part of your retirement portfolio, JNK and HYG are not appropriate for you. As has been said many times, "they are called junk bonds for a reason." Junk (non-investment-grade) bonds are much riskier than investment-grade corporate bonds. If you are a shorter-term, speculative investor knowledgeable regarding the corporate bond market, you may do well holding JNK or HYG during some time periods but not during others.
All of the above bond ETFs, and like bond ETFs and mutual funds, have the same weaknesses:
(1) The yields are so low that, with probable defaults and taxes factored in, you figure to not beat or only beat by a limited amount the rate of inflation. (In making this statement, I am figuring a probable longer-term inflation rate of 2.22%. You may figure a significantly different probable longer-term inflation rate.)
(2) In the longer-term, there is a stronger possibility of interest rates rising than there is of interest rates falling; hence there is a stronger possibility of a loss in share value (in addition to that due to defaults) than there is of a gain in share value―and the loss in share value could be large, particularly for long-term U.S. Treasuries.
Although some of the municipal and corporate bond funds may be profitable beyond the rate of inflation longer-term, none of the bond funds appear attractive as longer-term investments.
Here are four things you can do in response to this situation:
(1) Overweight stocks versus bonds. If you are young enough or the investments are for your speculative (versus retirement) portfolio, it may be wise to forego or very largely forego investing in bonds for a while. If the investments are for your retirement portfolio, the older you are, the riskier it is to not own a significant amount of bonds versus stocks. At a certain age, not owning a significant amount of bonds versus stocks in your retirement portfolio is too risky. You can overweight stocks in relationship to the amount you would normally own, but you should still own a significant amount of bonds.
(2) Buy local-currency bonds from a country outside of the U.S. with higher interest rates and/or probable currency appreciation versus the U.S. dollar. This is a practical option for certain international investment pros, but impractical for the average investor. Lack of sufficient knowledge and access are reasons why. Increased risk (i.e., the addition of currency risk) is an additional factor.
(3) Avoid bond types that are less attractive than other bond types. Currently, I don't think longer-term investors should own a U.S. Treasuries fund or a fund with a significant amount of U.S. Treasuries in it. Mortgage-backed securities are a less attractive longer-term investment as well. (I intend to write a separate article about mortgage-backed securities.)
(4) Buy CDs to hold until maturity instead of owning bonds or as a portion of your bond portfolio. Currently at least, if you shop well for CDs, you should get a significantly higher yield than you can for U.S. Treasuries with like maturities. Unless you keep too much money in the same financial institution, if you hold the CDs until maturity, you cannot lose any principal. If the CDs are for a long enough term, when the CDs mature, the environment for holding U.S. Treasury, municipal bond, corporate bond, et cetera funds should be improved. If you need or want bond or bond-like investments in your portfolio, I suggest you use DEPOSITACCOUNTS.com to search for the best CDs available to you. (The author has no association with DEPOSITACCOUNTS.com.)
A minor downside to buying CDs and holding them to maturity is that their principal value does not tend to rise when stock prices fall (and vice versa). Also, maybe it will be a while before municipal and corporate bond interest rates increase significantly; so you may want to hold a mix of investment-grade municipal bonds, investment-grade corporate bonds, and CDs in your retirement bonds portfolio. This, in conjunction with overweighting stocks, is the approach I currently favor.
Additional disclosure: I recommended and am managing an investment in LQD; and I am managing mutual fund investments with similar holdings to PZA, MLN, and TFI.