The Bond Rally Rolls On

U.S. Investors continued to pile into bonds during August.  Is this a rational response given that the 10 year U.S. Treasury Certificate currently yields only 2.7%?  The answer may depend on investors expectations regarding future inflation,  or possibly deflation.  If current inflation measured by the consumer price index (CPI) is zero,  bond holders will receive a real yield (yield adjusted for inflation) or 2.7%.  Based on historical trends,  a 2.7% real yield is an attractive return for a 10 year Treasury Bond. Some critics have suggested the CPI measurement is outdated  and does not fully account for current consumer spending habits. For example, consumers are gobbling up LCD TVs and other electronic gadgets despite the downturn-- and prices of these items have significantly decreased over the past few years. Critics argue these price reductions are not fully incorporated into current CPI measurement.  If the critics are correct, government CPI measurements are overstated!  If true CPI is actually decreasing by 2%,  we are in a deflationary environment and real yields on the 10 year Treasury Bond are 4.7%. That suggests bond investors are not only behaving rational but they may be pretty savvy investors. 

Earlier this year, we commented that the Federal Reserve was subsidizing riskier bond yields by holding down short-term interest rates. 

Is There Any Life Remaining in the High Yield Debt Party? 

These riskier investments provide yields 1%-6% above the 10yr U.S. Treasury. Based on our analysis above, municipal bonds would provide a real yield in the range of 6.7% and high yield bonds in the range of 10.7%.  This may explain why bonds continue upward. And with the possibility of  higher tax rates in 2011,  traditional municipal bonds provide an even better after?tax real yield.

Several caveats to consider are that rates are at long-term lows (see the chart); so eventually, yields will increase driving bonds prices down and bond holders will incur losses. 

Comparison of Municipal Yield vs. Treasury Yields

Source: Bloomberg, The Tax Foundation.

Municipal bond critics argue state governments are in danger of defaulting on their obligations.  But as the chart below demonstrates, history does not support this position. 

10-Year Average Cumulative Default Rates for Municipal and Corporate Bonds   1970 ? 2009

Source: Moody?s Investors Services, February 2010.

We anticipate low inflation or even deflation over the next several years and continue to seek bonds we believe reward investors for accepting higher levels of default risk.