It’s time to get the heck out of bonds, there’s a bubble about to pop

bubble_popI’ve spoken before about my portfolio being about 92% stock (mutual funds, etc.) and about 8% bonds. A couple of days ago, I decided it was time to make a change and get out of bonds. Below, I will tell you why you should consider doing the same.

Before you consider doing what I’ve done you must understand that what you should do depends on your age, risk tolerance, and a multitude of other factors. For me, in my early 30’s, I’ve got 30 or more years of investing in the market left. Having said that, I’m of the belief that I should be as risky as possible right now as long as I remain diversified. Although bonds are a way to preserve capital, or preserve it in times of major market declines, when markets are bullish you’re probably losing money in bonds to inflation.

With the above disclaimer out of the way, now I’ll speak to why I’ve gotten rid of virtually all of my bond holdings. First off, as mentioned, I wanted to take more risks, the paltry returns on my bonds do not provide enough incentive for me to keep them. I would rather take more risks for the opportunity to get more in return for my investments. I’ve shifted those bond dollars into value and growth stocks. Secondly, I, like many others feel there is a major bubble brewing in the bond markets as so many people flocked to bonds in the past year or two. We’re recently been experiencing deflation as a result of many factors including unemployment and in turn lower consumer demand. However, as the economy turns around and companies begin making a profit again, inflation is inevitable. Once inflation creeps in, investors holding bonds will be hurt and most probably don’t even know it.

This Wall Street journal piece summarizes this predicament quite well:

“If yields are low, like now, and inflation takes off you can get into trouble. Those who invested in long-term Treasury bonds in the mid-1960s, just before inflation surged, actually lost money in real terms over the following 20 years. (Those who bought bonds in the early 1980s, when yields went as high as 15%, made out like bandits as inflation collapsed.)

When inflation rises the government usually raises short-term interest rates. And that’s an additional problem for bondholders. When short-term savings accounts are paying about 1% a year, a piece of paper from a company promising 3.8% a year for 10 years can look quite valuable. But it’ll be worth a lot less if short-term rates were to rise to, say, 5%, or even more.

Are we definitely in a bond bubble? Even though prices seem high, it’s not certain. Some people argue that they are a reasonable value, and inflation will stay subdued. Indeed one or two bearish strategists argue bonds could go even higher, and yields lower. Only time will tell.

There are very few certainties in the financial markets. For private investors, the key is to make sure you’re getting paid for the risks you’re taking. In the case of anyone holding long-term bonds, you’re probably not.

Now you’re asking yourself “Well, what should I do”? Once again, that same wall street journal article summarizes some very practical tips to help combat this problem:

What can you do about it? Here are three practical steps to take if you are worried:

1 Limit your exposure to very long-term bonds. These are the ones most at risk from rising inflation and interest rates. Most people invest in bonds through mutual funds that have a mix of short-, medium- and long-term bonds.

How does your fund stack up? Just check the duration. That’s a technical term that’s the best measure of a bond’s inflation and interest-rate risk. Longer-term bonds have longer durations. The fund company will post this number, usually on the monthly fact sheet on its Web site.

A short-term fund will usually have a duration of a few years. You will earn less money in short-term bonds, but you will face fewer risks. A fund with a duration beyond about six to seven years is taking on more risk.

2 Move some bond money into TIPS. Treasury Inflation-Protected Securities are bonds with built-in inflation protection. Right now, the 20-year TIPS bond promises to pay about 2% a year on top of inflation. By historic standards it’s not steal — but it’s OK.

It offers a much better tradeoff between risk and reward than the regular long-term bonds. And it lets you sleep easy at night. With TIPS, you no longer have to worry about inflation. Bond prices can still move, but rarely by much — and if you hold the bond for 20 years, it doesn’t matter at all.

3 Consider some dividend stocks as well. Too many investors think in simplistic silos — stocks are risky, bonds are safe, and so on. Yet stocks of many solid, blue-chip companies may prove very safe investments, especially if you buy a basket of them, and you buy them when they are cheap. (Meanwhile, bonds may prove very risky, especially if you buy them when they are expensive.)

Over time, stocks also have typically offered better protection against inflation than bonds.

You can find plenty of decent yields without going near the high-risk financials. Take these exchange-traded funds: The Vanguard Consumer Staples ETF, which invests in such companies as Procter & Gamble, Wal-Mart Stores, Philip Morris International and Kraft, has a dividend yield of 2.6%. The Vanguard Telecommunications Services ETF is yielding 3.8%, and the Vanguard Utilities ETF, 4%.

Do your homework and understand what you’re owning, but many blue-chip stocks with good yields can be a good addition to an income portfolio.

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