When investors think of “risk aversion,” typically treasury bonds, corporate bonds and municipal debt rank highly on the list. In today's economic climate, however, it appears there may be more risk in low yielding debt than there is in stocks themselves, which are generally considered to be the most risky.
The Flee to Bonds
With deflation concerns brewing through the markets during the credit crunch, investors fled to cash, fixed income and other investments to protect themselves from dips in the market. A deflationary environment would make cash more valuable as the market hemorrhaged leverage from itself, decreasing the overall wealth of the world.
Bonds would make an even better investment, investors believed, because not only would investors be protected from deflation, but they would also earn a return on their purchases. With so much cash entering the bond market in what was a matter of days, bond prices skyrocketed and yields plummeted, as investors were willing to accept the smallest of returns just to have a safe “store of value” for their cash.
Bonds Could Be the Next Popped Bubble
After posting gains of more than 50% since March, the lowly yields offered on most corporate and government bonds appear more like a rounding error than a return. As investors shift in sentiment from protecting their wealth to growing their wealth, stock prices will soar as bonds lag the market.
Interest Rate Hikes Coming Soon
Investors should pay very close attention to the Federal Reserve when trying to time the great bond exodus. Currently, the Federal Reserve is keeping the overnight low at its lowest point in history, 0-.25%. However, many analysts are expecting that in the first or second quarter of 2010, the Fed could start raising rates to curb inflation and to briefly cut the money supply to pause future inflation.
Of course, the interest rate set by the Fed greatly impacts the price of bonds; as rates rise, bond prices move in the opposite direction to push yields higher. This will be the breaking point. Many corporate bonds are currently trading at a premium price, meaning the market price of the bond is more than the value of the actual bond. This results from the opposite trading between price and yield, where investors drive the price up if they are willing to seek a smaller yield.
Short Term Losses, Long Term Stagnation
Bond prices have likely reached their peak. Should an investor buy into a bond today, it is most likely that he or she will lock in the current yield of the bond and experience paper losses as bond prices move downward and yields move up. It is important to note that you only get the yield and price that you buy, and should yields move up 2-3%, your investment would still be earning the same return, while the value of your bond would have dropped by the same 2-3%.
Playing it Safe
Luckily, bonds are as varied as stocks. If you do plan to stay on the bond route, there are a few categories that may be better than others. Treasury and state municipal debt should be last on the list, as these debt obligations were perceived to be the safest at the onset of the financial crisis and currently carry a higher than normal premium due to strong demand for the bonds.
Investment grade corporate debt is one of the better risk/reward bond categories, as the returns are tied to a company's ability to repay the debt. With so many disappointing earnings reports over the last year, corporate debt was perceived to be less safe than government debt – which means it carries a much smaller premium.
If you're willing to accept more risk to avoid any substantial premium, junk debt investments are still carrying lofty returns, but come with the added risk of a weak credit risk.
An Alternative to Bonds
High dividend stocks remain a very competitive contender in the fixed income space. Prices for stocks were slaughtered across the board in 2008, and many companies are still paying the same dividend despite falling equity prices. If you wish to avoid the US in your investments, the exchange-traded fund WisdomTree DEFA Equity Income (DTH) yields more than 11% and has no exposure to any US stock.