Wednesday, September 22, 2010

A Look at Bond Markets

In this blog, I often focus on what is happening in the stock market, perhaps at the expense of discussing bonds. Well, some interesting things have been happening in the world of fixed-income. The first is that super-safe bonds, US Treasuries, are looking pretty risky right now as this WSJ article explains. With interest rates as low as they are, it is likely that they will go up again in the near future. This means that anyone holding these low interest rate bonds will see their value go down as interest rates rise. The price drop is more severe the longer the term of the bond, so it is much worse for 10 year bonds than it is for 2 year bonds. The graphic below from the above referenced article shows some past periods when holders of "safe" US Treasuries suffered significant losses.

This is also why we have always recommended owning bonds with close to a 5 year maturity, which reduces this "term risk" inherent in longer term bonds.

The other interesting development is the improvement in the corporate "junk" bond sector, discussed in this article. A Moody's executive quoted in the article says "The rebound is breathtaking." The graph below shows that default rates on junk bonds have returned to their pre-crisis level.

We generally recommend owning "junk", known as high-yield bonds, as part of a diversified investment portfolio, precisely because they behave differently than safer bonds, and this diversification can help the long-term performance of a bond portfolio.