Are Bonds Too Cheap?

As the economy slowly recovers from the worst financial crisis in decades, it's getting likelier by the day that the Federal Reserve will soon wind down its stimulus programs. In an effort to boost the economy, the Fed embarked on initiatives such as holding short-term rates at zero and purchasing billions in long-term bonds every month.

Now, fears that the Fed will soon draw down its stimulative asset purchases have sent the bond markets reeling. Longer-term rates are spiking, and as a result, bonds are plunging.

With economic data signaling a modest recovery, perhaps the Fed is overly optimistic. Do bonds represent a decent investment at current levels? Or is the sell-off just beginning?

A disastrous month for bonds
Bonds all across the risk spectrum are taking it on the chin in August. The market's "taper tantrum" resulted in higher rates across the board and, by extension, lower bond prices.

The sell-off has not been limited to lower-quality bonds. Highly rated corporate bonds are also suffering. The iShares Investment Grade Corporate Bond Fund (NYSEMKT: LQD  ) lost 4% through the first three weeks of August.

The yield on the iShares Investment Grade fund is now near 4% -- its highest level since early 2011. Considering that the 10-Year Treasury Bond yields just 2.8%, investors are getting a fairly attractive opportunity.

From an underlying credit-quality perspective, though this fund looks strong. Almost 60% of the iShares Investment Grade Corporate Bond Fund's holdings are rated "A," "AA," or "AAA." As a result, investors don't have a great deal of credit risk to worry about.

Even high-yield bonds, which were already sporting generous yields before interest rates started surging, have lost value in recent weeks.

The SPDR Barclays High Yield Bond Fund (NYSEMKT: JNK  ) has dropped sharply in the past few months and now yields 6.5% -- its highest yield since early 2012.

Investors should note that high-yield bonds have worse credit ratings than higher-rated issues. At the same time, 6.5% is nothing to sneeze at, and investors are at least being handsomely compensated for the heightened level of risk.

Meanwhile, preferred stocks haven't been spared any carnage. "Preferreds," which carry elements of both bonds and stocks, have taken a beating in August.

Consider the John Hancock Preferred Income Fund (NYSE: HPI  ) , which has lost more than 16% of its value in just three months.

Preferred stock is commonly known as a hybrid security that displays characteristics of both debt and equity securities. Like bonds, preferred stock receives coupon payments ahead of equity holders. Like traditional equities, preferred securities hold a subordinate position to a company's bonds.

The recent spike in interest rates has caused this fund to crash, sending its yield past 9%.

It's understandable for investors to flee from fixed income in times of rising rates, but the yield on the John Hancock fund is now 650 basis points better than the yield on the 10-Year Treasury Bond. Cash still pays nothing, so the John Hancock fund may offer a great opportunity to income investors looking for yield.

The Foolish takeaway
The Federal Reserve may apply the brakes on its massive stimulus program as soon as next month. The possibility alone has shaken the confidence of the capital markets. Higher interest rates have resulted in lower bond prices over the past several weeks, and if rates are set to rise further, this trend may continue.

At the same time, it's also possible that the Fed will not completely cut off the spigot, considering that unemployment is still painfully high and GDP growth is nothing to brag about. Should the Fed decide to continue quantitative easing, we'll likely look back on the current environment as a buying opportunity for bonds.

Investors who need income, such as those in or nearing retirement, should continue to hold bonds and consider buying now that prices are at more advantageous levels.

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