What's Next in the Bond Market?

Bonds had a huge upswing in 2009 and many are wondering with interest rates so low (and nowhere to go but up) as well as a mounting deficit that may lead to increasing inflation, what's the best course of action. In short, just as there is no way to time the stock market, there is likewise no way to time the bond market, and in investing, there is no free lunch. You can't reduce risk and increase reward; nothing is guaranteed. Having said that, due to the various unusual economic conditions at play, I do think investors can make certain movements in their bond investments that have a higher likelihood of paying off.

John Waggoner argues in a recent USA Today article, "Those who dived into bond funds due for splash of reality," that "there is no good reason to own a bond fund." Investors put a record $349 billion into bond funds through November. Because of rising interest rates and inflation in the next few years (which seem to be reasonable bets), bonds have nowhere to go but down as their NAV takes a beating in these conditions. Waggoner recommends looking at laddering bank CDs and purchasing TIPS.

I hardly think it's the case that there's no good reason to own a bond fund as it offers diversification and there's no way to time the market. Having said that, because of the conditions mentioned above, I do think is a viable action to shorten the average duration of your bond funds (i.e. go to short-term) and perhaps be lighter on moderate and long-term treasuries and heavy on TIPS. As interest rates rise, short-term bond funds' NAV will be hit much less than those with longer durations. Similarly, treasuries are more likely to take a beating than corporates, although some prefer to safety of treasuries as it's backed by the full faith of the US Government.

In the end, I think it's reasonable that if you have 100% of your bond allocation in a total bond market index such as VBMFX, to put 50% of that into a different investment such as TIPS, a CD ladder, or a short-term bond fund. What bond fund to choose? Well, two popular choices these days are VFSTX (Short-Term Investment Grade) and VBISX (Short-term index containing ~50% Treasuries and 25% government backed).

In 2008, VBISX was up 5.4% while VFSTX was down 4.7% (we're talking total return not just capital appreciation), while in 2009 VBSIX was up 4.3% and VFSTX was up a whopping 14.0%. So, as you can see, the risk/reward profile of VFSTX (and it's volatility) is certainly greater than that of the more diversified VBISX. The reason corporates performed poorly from late 2008 into early 2009 was that the safety of US Treasuries was alluring to investors as the economy was still on shaky ground, so corporates went way down in price while treasuries went up. At current levels, however, situations have reversed and many think US Treasuries are overpriced while corporates have already seen the worst and are undervalued in regards to their NAV. (Considering yield to get a better grasp of total return is also significant. Don't chase yields, however. Just for the record, VBISX is current yielding 2.85%, while VFSTX has a yield of 3.95%. A bond fund with a higher yield nearly always contains higher risk.)

It comes down to what risk/reward profile you want to take in your short-term bond position. Corporates are riskier by the mere fact that the chance of a corporation defaulting is higher than that of treasuries. Thus, if you want to take the risk of a higher return with also the caveat of knowing there's a possibility of a negative return (and are willing to hold through that instead of taking part in panicked selling), then short-term investment grade seems like the wise choice. Jason Zweig thinks in the current conditions corporates are the way to go. Note that while I'm saying "higher risk," this risk of VFSTX pales in comparison to high yield or junk bonds as well as all stock funds. So, we're not talking about a super risky asset class. The worst case scenario is pretty much 2008 when it was down almost 10%. If you want to play it more safe and the purpose of your bond holdings is for steady income, choose VBISX (or even VSGBX, Short-Term Federal) as it's more stable and has higher quality bonds.

Here is a nice summary from Schwab about what to expect out of Treasuries and TIPS, government mortgage backed securities (MBS), corporates, municipal bonds, high-yield/junk, and foreign bonds in 2010. To recap that article, they assert that: 1.) TIPS offer a better value than Treasuries, 2.) MBSs have limited upside, 3.) Investment-grade corporate bonds provide a benefit in the realm of higher yields, 4.) Muni bonds remain attractive for high-income investors, 5.) Junk bonds have run their course and have limited upside, and 6.) The weak dollar is driving the returns for international bonds.
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