The price of bonds moves inversely with interest rates; that is as interest rates move up, the price of bonds goes down and as rates go down, the price increases. Thus, conventional wisdom would lead you believe there is not much upside in bonds with today’s low interest rates. Or is that really the case?
If the federal reserve follows what Japan did in 2001 by purchasing of government bonds to revive the economy, it could drag down long-term rates after short-term rates hit zero. This is a possibility raised by Fed Chairman Ben Bernanke.
Japanese commercial banks cut back on lending and became huge buyers of government bonds after the stock and real estate bubble burst. Kazuhiko Sano chief fixed-income strategist at Nikko Citigroup said:
“After the injection of public funds into Japanese major banks in 1999, domestic bank holdings of JGBs kept rising until 2004 or 2005. Their behavior may give hints on the future actions of U.S. banks.”
According to Akihiro Nishida, senior fixed-income strategist at Mitsubishi UFJ Securities:
“The Fed has already aggressively intervened in the market to lower yields or crush yield spreads in an effort to influence prices that have been distorted. Who knows, yields could hit zero if the Fed becomes so aggressive and says it will purchase Treasuries in unlimited amounts, though I don’t think that would happen in one leap.”
This may be a good time to consider adding long-term or intermediate-term bonds to your income portfolio. If you don’t want to hold the bonds directly, you might consider an ETF or bond mutual fund. Here are two of each that I am looking at (yields as of 12/16/2008):
Vanguard Long-Term Bond ETF (BLV) – Yield: 5.28%
The Fund seeks to match the investment performance of the Lehman Brothers Mutual Fund Long Government/Corporate Index. Holdings include:
- Corporate Notes/Bond 51.5%
- Treasury Notes/Bonds 40.2%
- Government Agency Securities 6.5%
Vanguard Intermediate-Term Bond ETF (BIV) – Yield: 4.63%
The Fund seeks to track the performance of the Lehman Brothers 5-10 year Government/Credit Index. This index includes U.S. Government, investment-grade corporate, and international dollar-denominated bonds with maturities between 5 and 10 years. Holdings include:
- Corporate Notes/Bonds 49.6%
- Treasury Notes/Bonds 35.8%
- Government Agency Securities 14.3%
Baird Intermediate Bond Fund (BIMSX) – Yield: 5.39%
The Fund seeks an annual rate of total return, before fund expenses, greater than the annual rate of total return of the Lehman Brothers Intermediate Government/Credit Bond Index. Holdings include:
- Corporate Notes/Bonds 41.3%
- Government Agency Securities 21.7%
- GNMA and Other Mtg Backed Securities 19.5%
- Treasury Notes/Bonds 13.0%
Artio Total Return Bond Fund (BJBGX) – Yield: 5.39%
The Fund seeks to maximize current income consistent with the protection of principal by investing in a non-diversified portfolio of fixed income securities. Holdings include:
- GNMA and Other Mtg Backed Securities 55.3%
- Corporate Notes/Bonds 40.2%
- Asset Backed Securities 6.8%
- Government Agency Securities 2.7%
A drop in treasury yields is not a certainly even if the fed starts buying. The down side is you may end up holding a relatively safe investment yielding 4.5% to 5.5%. In this environment, that would be a nice problem to have if you have room for bonds within your asset allocation.
As always, you should never act solely on a recommendation. You should perform your own research and reach your own conclusion before buying or selling an investment security.
Full disclosure: No position in the aforementioned securities.