For years, investors have waited for bond rates to finally move higher. In the wake of the S&P downgrade, bond bears thought they'd finally get the catalyst they'd been waiting for. But with the one-two punch of a sluggish economy and the Federal Reserve standing by to do whatever it takes to jump-start it, Treasury bonds are making headlines for their record low rates in recent days -- showing that at least in this battle royal, Treasury has beaten Standard & Poor's soundly.
The victory of the Treasury over S&P is good news for bond investors. But before you assume that all your bonds have done well, remember that the bond market has more than just Treasuries. Different parts of the bond market are moving in different directions, creating opportunities in some corners while pushing smart investors away from others. Let's take a look at these different types of bonds and what could come next.
Treasuries: where the yields aren't
Every time you think Treasury bond rates have gotten as low as they can go, the market confounds those expectations by moving still lower. Rates on the 30-year Treasury have fallen to 3.5%, a sure slap in the face for S&P and its now-ridiculous-seeming downgrade. Treasury-oriented exchange-traded funds like iShares Barclays 20+ Year Treasury (NYSE: TLT ) have jumped more than 11% in just the first 10 days of August.
Inflation-protected Treasuries have seen even more movement. The real yield on 10-year TIPS is now negative at -0.20%, meaning that investors are voluntarily giving up purchasing power in order to link their returns to inflation. That's pushed prices on iShares Barclays TIPS Bond (NYSE: TIP ) up almost 4% for the month.
It's clear that Treasury buyers are either desperate to preserve their capital at any cost, or that they expect future capital appreciation as they believe rates will head lower still. Anything's possible in the short run, and with the Fed promising to stay on hold until 2013, betting on a bond rate rise has been very painful for investors.
Investment-grade corporates and munis: holding their own
Meanwhile, outside Treasuries, the outlook is much different. Corporate and municipal bonds have swung in either direction yet are roughly flat for the month so far.
Munis in particular have had to handle fallout from the U.S. debt downgrade. Because many municipal securities are backed by U.S. Treasuries, S&P decided that once it downgraded the U.S., it needed to downgrade those federally backed munis as well. That led to 11,000 muni bond issues seeing their ratings reduced to AA+. Perhaps surprisingly, though, the muni market didn't respond particularly negatively -- although it didn't see the huge gains that Treasuries earned. iShares S&P National AMT-Free Muni Bond (NYSE: MUB ) is up just a fraction of a percentage point in August.
High-grade corporates, on the other hand, arguably should have benefited from the Treasury downgrade. After all, with the downgrade, four companies now have better ratings than the U.S., and many formerly AAA-rated companies, including Berkshire Hathaway (NYSE: BRK-B ) and General Electric (NYSE: GE ) , are now on a par with the U.S. rating. But safe-haven investors like the uniformity of Treasuries and the fact that they don't have to assess the creditworthiness of each individual issuer. That has restrained investor interest and held iShares Investment Grade Corporate (NYSE: LQD ) to a modest gain of about 1%.
Junk is junk
Where the big plunge has happened is in the junk bond market. The SPDR Barclays High Yield ETF (NYSE: JNK ) is down more than 7% on the month.
The reason for that is largely that junk bonds tend to act more like equities than most other bonds. When default risk rises precipitously, bondholders stand almost as great a chance of losing money as shareholders. With Treasury yields shrinking, the spread between Treasuries and junk widened to its highest level since last October. With that gap exceeding 6 percentage points, yield-hungry investors may well start jumping at junk in the near future.
Know your bonds
The bond market's huge advance has stunned many investors. Yet in assessing your portfolio, you need to be aware of what bonds you actually own. If you have a fair mix of bonds, then you haven't earned nearly the gains that a quick look at the Treasury market would indicate. On the other hand, if you primarily hold one type of bond, you should consider the benefits that diversifying your bond allocation could have -- especially once current trends reverse.
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