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Bonds Aren't as Good as They Look

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The bond market has done just about everything it could to make investors not want to buy them. Yet despite all the storms that have pummeled bonds lately, investors keep on lining up at the trough to buy more. The obvious question is why -- and whether we're continuing on a course to become like debt-laden Japan, whose populace has long embraced Japanese government bonds despite their earning nearly nothing in interest for years.

Why bonds look terrible
On one hand, you'd expect that bonds would be more unpopular than ever right now. Between Standard & Poor's decision to put a negative outlook on U.S. Treasury debt, the ongoing standoff between Congress and the Treasury regarding the debt ceiling and the government's power to borrow, and the coming end of the Federal Reserve's quantitative easing program, bond prices are under plenty of pressure.

But rather than giving in to that pressure, bond prices have actually risen, pushing down interest rates. The yield on the benchmark 10-year Treasury is down to just above 3%. Short-term inflation-adjusted TIPS bonds still have negative yields. And mortgage rates have hit their 2011 lows recently.

All this evidence to the contrary, two factors may explain investors' love of bonds. Let's take them one at a time.

1. Performance chasing, revisited
On a forward-looking basis, current interest rates on bonds may look low. But most people own bonds through funds, and when you look at past returns on bond funds, they've fared pretty well.

For instance, the iShares Barclays 20+ Year Treasury Bond ETF (NYSE: TLT  ) , which caters to those seeking long-dated exposure to bonds, tumbled late last year as some believed that rates would imminently rise. But since the beginning of the year, the ETF is up more than 4%. That doesn't match the S&P 500's year-to-date return of about 6%, but for five months, 4% is a respectable return.

Other bond funds have done even better. iShares S&P National Muni Bond (NYSE: MUB  ) is up 6% so far in 2011 as past fears of municipal problems have subsided, at least for the moment. Junk bonds are also up, with SPDR Barclays High Yield Bond (NYSE: JNK  ) up more than 5%. And with inflation having heated up recently, iShares Barclays TIPS Bond (NYSE: TIP  ) is up 4.6%.

In the longer term, the returns are even more striking. Five-year returns on the iShares TIPS ETF weigh in at almost 6% annually, doubling the S&P 500's 2.8%. The long-term Treasury ETF has done even better, rising 6.7% per year. Meanwhile, those betting against bonds using inverse ETFs like ProShares UltraShort Treasury (NYSE: TBT  ) have lost their shirts in recent years.

2. No good alternatives
Bonds aren't sexy. But it's been long enough since they've posted big losses that many investors have forgotten that they can in fact lose money with bonds.

That certainly isn't true with popular alternatives to bonds. Dividend stocks may be appealing, but investors haven't forgotten how high-yielding financials such as Citigroup (NYSE: C  ) and US Bancorp (NYSE: USB  ) slashed their payouts in 2008 and 2009 to conserve cash and meet the requirements of government assistance programs like the Troubled Asset Relief Program. REITs have posted strong returns in the past, but many misunderstand their relationship to the real estate market and don't properly assess their exposure to weak home prices. Even gold and silver have proven recently that they're subject to huge price swings that destroy their value as secure hedges for conservative investors who don't want high portfolio volatility.

As a result, for many, bonds are the only game in town. No matter what the price, bond investors have demonstrated their unwavering dedication to buying bonds.

What's coming
Meanwhile, the foreign entities that have helped finance the government's debt are poised to reduce their holdings. That may leave U.S. investors to fill the gap. And if that happens, then we could easily end up looking like Japan, where 94% of the public debt is held domestically. With so much money locked up in public debt financing, the private economy could find itself unable to get the capital it needs to grow, creating a vicious cycle of deteriorating financial strength.

Bonds continue to lure investors with their past success and apparent safety. Unfortunately, future investors may well discover that they'll get neither from their current bond investments.

Learn the basics of financial planning in our 13 Steps to Investing Foolishly. It'll get you on track to a great financial plan in no time.

Tune in every Monday and Wednesday for Dan's columns on retirement, investing, and personal finance.

Fool contributor Dan Caplinger won't get fooled by bonds. He doesn't own shares of the companies mentioned in this article. 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 a true looker.

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