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Are Bonds Really a Conservative Investment

It has long been a common assumption that bonds deserve to be a core allocation in any balanced portfolio--especially if the investor is nearing retirement. Bonds are lauded for their steady and predictable coupon payments, repayment of principle, and are typically viewed as "less risky" than equities. However, interest rate risk and inflation can undermine fixed income returns. Both issues are quite relevant currently.

The first issue to examine is interest rate risk. Bond values and interest rates have an inverse relationship. This means that when interest rates are falling due to Fed intervention or natural forces, the value of bonds increases. If a bond investor is fortunate enough to buy before rates fall, he or she will be positively impacted. However, the more dangerous scenario involves rising interest rates. An investor purchasing bonds during a trough in interest rates will have the misfortune of watching the value of his or her bond diminish as rates rise. 

The chart below shows rate history for the 10-Year Treasury Note. As a result of government intervention, rates are currently hovering near all-time lows, and seemingly miles away from rates in the late 1970s and early 1980s when inflation was running rampant. It would seem that the only direction rates can go is up which, of course, means bond values must necessarily go down.

The long term investor planning on holding a bond to maturity would argue that changes in interest rates aren't of any concern. He would contend that my previous discussion involving the fluctuating value of a bond are only pertinent to short term investors. The hypothetical long term buyer does not mind seeing a constantly changing value because the rate at which he bought is locked in and any price movements are just "noise" if he holds to maturity. This savvy investor would be correct. Buying today, he or she would earn 3.3% on the 10-year by holding to maturity. In past years, this buy and hold approach would be prudent, but doing so in today's landscape could prove harmful to one's wealth. 

When reviewing an investment's success, it is important not just to consider the nominal return but also judge if purchasing power has been preserved, increased, or decreased. This is referred to as an investment's real return which simply means the return after accounting for inflation. A return of 3.3% really takes on a different look when inflation is brought into the picture. The chart below shows the history of inflation in the United States as measured by the CPI. In years during which inflation was high, it is very possible that bond investors earned a negative return.

Investors should be wary of purchasing fixed income securities. There is a reason many corporations have been issuing bonds. According to Morningstar, December 2010 net debt issuance rose 10% year over year. This is during a time when corporate balance sheets have been at their strongest with many firms holding an unprecedented amount of cash. Corporations get cheap money at the expense of investors earning poor and possibly negative real returns. Interest rate risk and inflation risk make the fixed income arena appear to be a dangerous place. Buying today could cause a deterioration of one's purchasing power.

While the bond market should be avoided, there are still well suited alternatives for the investor seeking income. I'll discuss these very attractive securities in my next article titled "Alternative Bonds...With Unlimited Upside."

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