Most people invest in bonds because they want to have stable fixed income. Because the performance of bonds are very stable, they also serve to reduce the volatility of the overall portfolio. Depending on the weighting from 0% to 100%, you can reduce your stock volatility correspondingly. With regular re-balancing between your stocks and bonds, you should be able to “sell high and buy low” in your stock portfolio, and use your bonds as a stable source of income.
Everything sounds good so far, but the most attractive feature of fixed income is also its greatest drawback — the income is FIXED. It does NOT increase as time goes on, and inflation keeps reducing your principle and interests into nothingness. Since inflation is almost always there, you’ve got a real problem especially when you’re investing long term in long term bonds.
Normally, this problem is resolved through obtaining higher interest yield on your bonds to compensate for your inflation risk. Assuming that your obtained yield is always higher than the inflation rate, you will not have a problem. Your actual income from bonds however should be on an after-inflation basis, and after-tax for that matter.
Vice versa, if the economy is undergoing a phase of deflation (usually caused by economic recession or depression), it is very advantageous to invest in bonds. Not only do you get a fixed income while everything is falling off the cliff, but the purchasing power of your principle just keeps getting better. From 1980 to 2001, the US and the world in general experienced one of the most prosperous economic eras. During that period, the nominal inflation rate was relatively low while the economic expansion kept going strong.
In the spring of 1980, when Fed Chairman Volker hiked interest rate to stratospheric a 15% in an attempt to save the dollar from further depreciation and to put a stop on double digits inflation rate, it was actually close to the peak of inflation. When interest rates peaked, bond prices were low (interest rate increases lead to lower bond prices) and created an excellent opporunity to invest in bonds. At that time, if you had invested in bonds, you could have locked in some 10% to 15% annual yield rate for the length of the bond you purchased (like 30 year treasury bonds).
Source: Yahoo! Finance
After an almost 20 year bull market in bonds, I personally believe that we are embarking an era where the inflation rate is heightening (at least in the US), which will force bond interest rates to stay high if not go higher. I encourage you to study the inflation chart from inflationdata.com, a great site for historical data research, to gain some historical background. I also believe that in coming years bonds are probably not the best investment because of the huge debt overhang on the US dollar.
Bond Hedges
If you’re interested in playing against a bond bear market, one can actually “short bonds” by borrowing a big amount from a fixed term loan, such as home mortgage. Assuming that bonds are not a good investment, “shorting bonds” by having a mortgage will work to your advantage by essentially reducing your real payments over time because of higher inflation.
A riskier hedge against bonds is to invest in gold & silver and natural resources. In any case, I would suggest that instead of investing your money in bonds which generate a fixed income, you should probably invest into a dividend-paying stock, preferably one who ties its dividends to the price of natural resources. Yes, it may be more volitile, but in the long term your dividends can keep pace with inflation and the price of the natural resources. Here is a list of high yield dividend stocks, yield from 6%+ to almost 20%, mostly tying their dividends to price of gas/oil, or its related business.
TIPS are for waiters?
Protection of your inflation-adjusted principle is the most important thing in investing. There are times when investing in bonds is wise, but now is probably not one of those times. You may argue your case for investing in TIPS, treasury inflation-protected securities which have interest yields indexed to CPI. But I cannot trust a Fed that hides M3 money statistics, nor a government that uses hedonic adjustments on CPI to bail you out of inflation. Plus income from TIPS is taxed, so even if your initial income is inflation-adjusted, taxes will take their toll.
More Bond Resources
For more resources on investing in bonds, check out Chris’ article What are Bonds? here on InvestorGeeks. I’ve also posted a series of articles on bonds on my site 1stMillionAt33: