The Wall Street Journal made an interesting observation recently, “Treasury bonds are priced for the end of the world.”

It was a news article, not an opinion piece. But it happens to be the viewpoint of virtually every investor with half a brain – or a modicum of common sense. A few months ago, for instance, the world’s best-known investor, Warren Buffett, wrote in his annual letter to shareholders, “Right now bonds should come with a warning label.”

[ad#Google Adsense 336×280-IA]Yet I routinely talk to investors who still don’t get it.

Treasuries are safe they tell me.

And the historical returns are quite good, especially compared to the pittance money markets are paying.

Both of these statements are true. But it still makes little sense to plunk for 10-year bonds that pay 1.5% or 30-year bonds yielding 2.5%.

And if you’re holding an investment-grade bond fund whose yield is much higher than this, you really need to hit the exit in a hurry.

Here’s why…

The World is Not Ending

Let’s start with the fact that Treasury yields are at all-time record lows. Why is this? Inflation is modest. Uncertainty is high. The U.S. may sink back into a recession. The wheels may come off the euro. Uncle Sam seems like a safe bet.

And from a credit standpoint, U.S. Treasuries – even without their vaunted AAA rating – are indeed among the world’s safest securities. Sure, a few blue-chip companies have higher credit ratings. But that could change. Plus, they aren’t able to crank up the printing presses to repay their corporate debt. And some other countries have been fiscally responsible enough to maintain their AAA-ratings.

But most don’t have the economic strength, political stability, or military might to attract large capital flows.

Lend the U.S. government money and, yes, it will certainly pay you back. But two dangers loom: inflation – the great bugaboo of bond investors everywhere – and, ahem, the world’s not ending.

Let’s take inflation first. Consumer prices are fairly low, unless you’re looking at healthcare costs (or health insurance premiums) or putting a kid through college. The CPI was 1.66% for June, down from 3.56% a year ago. That trend could easily reverse, however.

Oil, for instance, tumbled more 20% in the first half of the year. But it has moved back up almost as quickly lately. If inflation ticks higher, bond prices will sink lower. Even a half-point rise in inflation could cause 10-year Treasuries to fall 5%. And that might be just the beginning. If you don’t know what happened to bond prices in the early 80s, you owe it to yourself to learn what happens to fixed-income investors when inflation and interest rates suddenly move higher. It’s not pretty…

“If It’s in the Papers, It’s in the Price”

Then there’s that matter of the world not coming to an end. I hear investors recite a litany of woes that beset the global economy today. But every one of these things – anemic GDP growth, currency problems in Europe, the already leveraged consumer, and so on – are already priced into stocks. As the old Wall Street saw reminds us, “If it’s in the papers, it’s in the price.”

As for those bond funds that, despite their high expenses, sport hefty yields, look out below. Many of them are highly leveraged – the bond equivalent of buying stocks on margin – and when bonds head south their shareholders will get routed.

It hasn’t happened yet. But it almost certainly will. In the meantime, with inflation at 1.6% and 10-year yields at 1.5%, bond investors are already earning a real negative return on their money.

What’s the point of owning an investment with very little upside potential and huge downside risk?

Govern your portfolio accordingly.

Good Investing,

Alex

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Source: Investment U