In my recent article entitled "Your Retirement Investments: Addressing the Bonds Dilemma", I expressed the belief that, in certain circumstances, your retirement investments should include municipal bonds, CDs, and/or corporate bonds. Some people don't agree with this position. They think that, at this point in time, the prospect for bond returns in the longer term are so poor that no investment should be made in them.
Diversification, the fact that bond and stock prices tend to move in opposite directions, and the fact that no one knows what the future holds for certain, are reasons for investing some portion of your portfolio in bonds anyway, even if you think the returns will be poor. Still, if the prospect for returns is poor enough, these reasons are not sufficient to justify investing any serious amount of money in bonds. Inflation is the reason often cited for why bonds may perform very poorly in the future. I am only projecting inflation to rise, from where it has been recently, to 2.22% in the longer term; so I am projecting its impact on bond values going forward to be moderate. (2.22% is the rate of inflation from 1871-2011.) You may view inflation as a greater threat though.
According to the Board of Governors of the Federal Reserve System:
"The Congress established the statutory objectives for monetary policy―maximum employment, stable prices, and moderate long-term interest rates―in the Federal Reserve Act. … The FOMC noted in its statement that the Committee judges that inflation at the rate of 2 percent (as measured by the annual change in the price index for personal consumption expenditures, or PCE) is most consistent over the longer run with the Federal Reserve's statutory mandate. … The maximum level of employment is largely determined by nonmonetary factors that affect the structure and dynamics of the job market. … As a result, the FOMC does not specify a fixed goal for maximum employment; rather, the FOMC's policy decisions must be informed by its members' assessments of the maximum level of employment, though such assessments are necessarily uncertain and subject to revision. In the FOMC's most recent Summary of Economic Projections, Committee participants' estimates of the longer-run normal rate of unemployment had a central tendency of 5.2 to 6.0 percent, roughly unchanged from about a year ago, but substantially higher than the corresponding interval several years earlier." (The full text is here.)
The inflation target is fixed. The employment target is moving and is more dependent on factors outside of the Federal Reserve's (Fed) control. Due to this, the inflation target trumps the employment target in significance. Unemployment concerns could lead to the Federal Reserve accepting a higher rate of inflation than the 2% target, but this affect should be limited. If/when it does accept a higher rate of inflation, if employment does not improve or improve enough, it indicates that there are reasons other than Fed policy making employment so weak and that the employment target is too high. I believe the Fed is going to do a good (but imperfect) job of keeping the inflation rate near 2%, as it has for the last 20 years or so.
The following data is found here within "Section 2 - Personal Income and Outlays". The first chart shows the annual PCE price index percentage changes from 1930 through 2011. Within the chart, please take special notice of the segments from 1993-2011 and 2009-2011. The second chart shows the monthly PCE price index percentage changes for 2011. (In both charts, the blue dots and line are the regular figures; and the gold dots and line are the core [excluding food and energy] figures.)
The core PCE price index changes have been about 1.45% from 2009 through July, 2012. This indicates that there has been sufficient slack in the inflation rate to accommodate the Fed's increasingly loose monetary policy. You and/or I may not agree with QE3, QE2, or QE1; but there has been sufficient slack in the inflation rate to accommodate it. The Fed will back out of the QE programs (i.e., sell the assets purchased via the programs, thereby lessening the amount of U.S. currency in circulation) when it determines that the time is right. The Fed will back off of other loose monetary policies, such as the 0.00-0.25% Federal Funds Target Rate, when it determines that the time is right as well. When the Fed says it "currently anticipates that exceptionally low levels for the federal funds rate are likely to be warranted at least through mid-2015", it means exactly what it says. (The full text is here.) It is only anticipating "at least through mid-2015". If inflation and/or inflation expectations increase enough, the Fed will tighten monetary policy, regardless of what it anticipated.
If you think that I have too much faith in the Fed, remember that, when it errs, it can be in either direction―monetary policy that is too loose or monetary policy that is too tight. It can be imperfect and still meet its inflation target in the long run.
Intermediate/long-term bond interest rates are more influenced by future inflation expectations than current inflation. According to the Cleveland Fed, future inflation expectations are generally consistent with the approximately 1.45% inflation rate currently being experienced. The following chart is from a Cleveland Fed 9/14/12 news release found here.
Basically, I project interest rates to only be about 0.77% (2.22% minus 1.45%) higher longer term in response to a rise in inflation; and I do not project this rise in inflation to occur soon and all at once.
To me, the greater current issue with bonds is that in the U.S. (and some other places), certain bonds are overbought independent of inflation. The Quantitative Easing (QE) programs and a bias toward safety due to the eurozone crisis and impending U.S. fiscal cliff have created greater demand for Treasuries and certain mortgage-backed securities. Also, this phenomenon, and the 0.00-0.25% Federal Funds Target Rate, may have created a greater interest in longer-term debt instruments in general.
The ETF price chart below is via Morningstar. The chart begins on 11/1/07 (before the most recent U.S. recession and the U.S. financial crisis), ends on 9/1/12, and is on a percentage basis. The expense ratios of the ETFs charted are 0.15% (NYSEARCA:TLT), 0.15% (NYSEARCA:LQD), 0.14% (NASDAQ:VCLT), and 0.28% (NYSEARCA:PZA); so their impact is limited. The ETFs charted are:
Dark blue: iShares Barclays 20+ Year Treasury Bond Fund
Yellow: iShares iBoxx $ Investment Grade Corporate Bond Fund
Red: Vanguard Long-Term Corporate Bond ETF
Light blue: PowerShares Insured National Municipal Bond Portfolio
All of these ETFs, except LQD, have similar bond maturity profiles. I pictured these long-term bond funds (i.e., TLT, VCLT, and PZA) because the price movements of long-term funds are the most volatile. I included LQD because VCLT does not have a track record that goes back to 11/1/07. Using the LQD price performance, we can speculate that, if VCLT did have a track record going back to 11/1/07, its price increase on the chart would have been about 0.73% greater. The end results would have then been:
TLT: +40.74% | VCLT: +24.69% | PZA: +2.19%
The Market Vectors® Long Municipal Index ETF (NYSEARCA:MLN) performed very similarly to PZA, although MLN's price history only goes back to 1/1/2008.
For each of 2006, 2007, and 2008, the core PCE price index change was 2.3%; so inflation has dropped about 0.85% (2.3% minus 1.45%) since 11/1/07. TLT has a weighted average maturity of 27.92 years. Given the 30-year U.S. Treasury bond rates of 4.74% and 2.68% on 10/31/07 and 8/31/12, respectively, and the 20-year U.S. Treasury bond rates of 4.79% and 2.29% on 10/31/07 and 8/31/12, respectively, we can calculate that in the ballpark of 16.38% of the 40.74% increase in TLT was due to inflation decreasing. (TLT's increase would have been 41.47%, versus 40.74%, less the impact of expenses.) VCLT and PZA have slightly shorter average maturities; so, for them, the 16.38% figure adjusts to 15.34% and 15.27%, respectively. When we subtract these theoretically-caused-by-inflation percentages from the end results for 11/1/07-9/1/12, we get adjusted end results of:
TLT: +24.36% | VCLT: +9.35% | PZA: -13.08%
With adjustments for expense ratios and defaults, we get adjusted end results of:
TLT: +41.47% | VCLT: +26.45% | PZA: +3.58% (with inflation impact)
TLT: +25.09% | VCLT: +11.11% | PZA: -11.69% (without inflation impact)
Plus whatever expenses and defaults turn out to be, these are the theoretical amounts that we can expect these ETFs to have reversed after things normalize, if normal includes 2.3% inflation. From 7/26/02-7/13/07, TLT and LQD had about equal price performances, considering that LQD should have lost some value due to defaults. TLT rose 2.28% and LQD rose 1.15%. From 7/13/07-11/2/07, there was a bit of divergence in the price performances of TLT and LQD, with TLT rising 8.08% more and LQD rising 2.31% more. Long story made short, this implies that TLT has about an extra 4.46% (because I converted the LQD number into a VCLT number) to reverse. With the extra 4.46%, the numbers become:
TLT: +45.93 (with inflation impact)
TLT: +29.55 (without inflation impact)
Treasury bond prices have been greatly affected by the QE programs and bias toward safety due to the eurozone crisis and impending U.S. fiscal cliff. We are all aware of that. What is interesting is that corporate and municipal bonds combined appear to not be experiencing a knock-on effect from the QE programs or 0.00-0.25% Federal Funds Target Rate and that corporate bonds appear to be overbought in relation to municipal bonds.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.
Additional disclosure: I recommended and am managing an investment in LQD; and I am managing mutual fund investments with similar holdings to PZA and MLN.