The Last Bubble - Bonds

Record low interest rates and investor appetite for safe investments has led to the creation of a new bubble - the bond bubble. In the first 10 months of 2009, investor plowed $313 billion more into bond than they took out.

Commenting on this, an article in SmartMoney said:

"A bond bust might not be as obvious to ordinary investors as a stock-market crash; there likely wouldn’t be the Pets.com-style flameouts we saw in 2000. But when they happen, bond debacles can have an insidious effect on people’s nest eggs. If interest rates were to rise, for example, and many analysts believe that’s a likely scenario, bond prices could get clobbered. Prices on even “safe” Treasury and municipal bonds could fall 30 percent or more if interest rates soar over the next few years; some corporate bonds could fall even more. “Even with government funds, people forget you can lose money,” says Carol Clark, investment principal at Lowry Hill, a money-management firm in Minneapolis."

So what's an investor to do? The yield on a 30-year Treasury Bond is 4.375% versus a 3.30% APY on the best 5-year CD rate. To get any decent rates on bonds you have to go long. If you need the yield, I'd go with the CD. First, it won't lose value regardless of what happens with interest rates. Second, you have some flexibility. You can always withdraw the money and suffer a penalty on the interest (not the principle). This is much less risky than holding a 30 year bond in a rising interest rate environment.

If you don't like CDs, then a short bond fund may be the way to go. Short bond fund hold shorter duration bonds and as a result are less sensitive to interest rates. Some of the bond funds offer attractive yields. For example, the The Fidelity GNMA Fund (FGMNX)  (Ginnie Mae) has a 30 day yield of 3.22%. It's duration is only 2.1% meaning you will only lose 2.1% of value for every 1% rise in interest rates.That's quite low by bond standards.

Bonds are new sweet spot for brokers. Be sure you understand the risks and potential downsides before you purchase bonds.

Sam Cass
Sam Cass: Sam Cass, MBA, JD, University of Texas at Austin. Always a fan of Leonardo Da Vinci.

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