Bonds Won't Stay Bulletproof Forever

With more than a decade of turmoil for stocks, Treasury bonds have stood out as a seemingly bulletproof investment, producing huge gains for those who stayed the course. But as threats seem to mount against bonds, can Treasuries really keep giving you the protection you've come to expect from them?

Will two be the charm?
Over the summer, investors worried over the potential impact of an unprecedented cut in the U.S. Treasury's credit rating. As Washington's wrangling over raising the debt ceiling pushed the nation to the brink of a possible default on government debt, Standard & Poor's finally decided that the combination of soaring deficit spending and political paralysis at the federal level warranted taking away its top AAA rating. Yet in the aftermath of that move, Treasury prices didn't fall, as many had expected. Instead, they rose, and they now carry some of the lowest yields in their decades-long history.

Now, the question is whether crying wolf a second time will have the same impact. Earlier this week, Fitch Ratings maintained its AAA rating on U.S. Treasuries but reduced its long-term outlook for Treasury debt from stable to negative. The move, which can often act as a precursor to an outright downgrade, draws a line in the sand, as Fitch suggested that by 2020, overall debt levels as well as the interest costs of maintaining that debt would rise enough to justify dropping the top rating -- without significant action.

Yet again, Treasury prices barely budged. Even with a big jump in stocks, the iShares Barclays 20+ Year Treasury ETF (AMEX: TLT  ) lost only a few pennies on the day, and based on its most recent monthly distribution, the long-term bond ETF now yields less than 3%. Shorter-term bond investments like the iShares Barclays 7-10 Year Treasury ETF (AMEX: IEF  ) weigh in at an even more meager 2.4%.

Don't bank on bonds
Bonds have unquestionably been a lifesaver for investors' portfolios over the past decade. But it's not likely to continue, if only because of a simple mathematical fact: With rates already so low, there's very little room for bond prices to rise further.

In early 2000, long-term bond rates were above 6.6%. As they gradually fell toward their current level below 3%, the value of those bonds and their above-market interest payments rose. That contributed the extra returns from price appreciation on top of those attractive yields, producing a very attractive total return.

But now, both of those tailwinds are gone. At less than 3%, a 30-year Treasury doesn't provide much income. And barring a situation in which investors are willing to pay the Treasury to own bonds, it's mathematically impossible for yields to match the drop of more than 3.5 percentage points between 2000 and now.

Conversely, if yields start rising back toward historical norms, then bond investors could easily see conditions that rarely occur: price declines could more than offset interest income, producing negative total returns for bondholders.

Defend yourself
The obvious bond alternative that income-hungry investors are flocking to are blue-chip stocks with dividends that beat those 3% returns. Even within the Dow, you can find several 3%+ yielders, including Intel (Nasdaq: INTC  ) , Johnson & Johnson (NYSE: JNJ  ) , and General Electric (NYSE: GE  ) -- and those stocks actually have some growth prospects to go with their income. Expand your view a bit more and you can find plenty more high-yielding stocks.

But even the safest blue-chips have risk that bond investors can't afford. To defend the fixed-income side of your portfolio, look to shorter-duration bonds or even bank savings accounts. Their rates will be lower, but they have far less exposure to potential losses. And with online savings banks from companies including Sallie Mae (NYSE: SLM  ) and Discover Financial (NYSE: DFS  ) offering 1% right now on federally insured deposits, safety still gets you a decent chunk of the income that longer-term bonds would provide -- along with the potential for increases in the future.

Treasuries aren't bulletproof -- and even though I was early with my initial call, I'm finally making my CAPScall for the iShares Barclays 20+ Year Treasury ETF to underperform the S&P 500 going forward. If I'm right, then bond investors who don't rebalance some of their exposure to less risky assets could be sorry.

Dealing with low rates is just one of the challenges of saving for retirement. The Fool's newest free special report, The Shocking Can't-Miss Truth About Your Retirement, has even more must-know information for every retirement saver.

Fool contributor Dan Caplinger tries to dodge bullets like Neo in the Matrix. He doesn't own shares of the stocks mentioned in this article. The Motley Fool owns shares of Johnson & Johnson and Intel, as well as having bought calls on Intel. Motley Fool newsletter services have recommended buying shares of Intel and Johnson & Johnson, along with creating a diagonal call position in Johnson & Johnson and a bull call spread position in Intel. 

Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool's disclosure policy is like a bulletproof vest surrounding your entire body.


Read/Post Comments (4) | Recommend This Article (7)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On November 29, 2011, at 12:21 PM, ozzie wrote:

    Silly Dan, don't you realize that interest rates only go DOWN forever? We're at 0% for 1-month, 3-month, 6-month, 1% for 5 year, 2% for 10 year and 3% for 30-year. So that just means further opportunity for bond buyers to drive the interest rates to negative for short term bonds (think of it as paying "rent" for parking your money with the U.S. Government) and toward 0% for the longer-term bonds.

    I know this sounds stupid and crazy, but it continues to be the "reality". I for one am anxious for reality to kick back in.

  • Report this Comment On November 29, 2011, at 9:18 PM, PostScience wrote:

    Shorting TLT has been my worst pick ever, both on CAPS and in real-life.

    Nevertheless, I am doubling down and hope to recoup all my losses plus a lot more once normal inflation resumes.

    Heck, without 5% inflation, how is the US ever going to pay off the debt?

  • Report this Comment On November 29, 2011, at 11:49 PM, techy46 wrote:

    I wouldn't short TLT but wou;dn't go long either. Sooner rather than later this funny money is going to start a real inflationary mess. It amy take another 1 or 2 but once it happens watch out.

  • Report this Comment On November 29, 2011, at 11:58 PM, rd80 wrote:

    You can get triple the leverage and the friction from the leverage working for you with a red thumb on Direxion Daily 20+ Yr Trsy Bull 3X (TMF).

    That leverage works both ways. The bond rally has made this red-thumb my all-time worst CAPS pick.

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