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Bond Investing That Avoids the Bubble

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Just about everyone knows that bonds are rapidly approaching bubble territory. Yields are at historic lows, pushing bond prices up to unsustainable levels. Headlines everywhere trumpet the fact that bond investors are going to be disappointed in future returns at the very least and are going to get absolutely killed at the very worst. But investors, nervous about a rapidly decaying global economy, keep stuffing money into the safety of bonds.

Despite their obvious disadvantages at this point in the market cycle, bonds should still be a vitally important part of many folks' portfolios, especially those in or near retirement. Fortunately, there are some areas of the bond market that are more attractively valued than others.

U.S. Treasuries
This is one sector of the bond market that is pretty richly valued. While the U.S. faces many long-term fiscal problems of its own making, we're still seen as the best of the worst on a global scale, so the push into Treasury debt has been pretty spectacular in recent years. But with the yield on a 10-year Treasury bond hovering around 1.5%, it's hard to argue this sector isn't pricey and that investors are being adequately compensated for their investment.

So think twice about stocking up too heavily here. You can (and should) own some Treasury bonds as part of a fully diversified bond fund like Vanguard Total Bond Market ETF (NYSE: BND  ) or iShares Barclays Aggregate Bond ETF (NYSE: AGG  ) , but reconsider adding a meaningful allocation in additional bond funds or ETFs that focus exclusively on this sector.

Investment-grade corporate bonds
Taking another step up on the risk/reward ladder are high-quality corporate bonds. These bonds aren't quite as safe as bonds backed by the U.S. government, but investors will be rewarded for taking on that extra bit of risk. While default risk is higher here than for U.S. government bonds, you're still fishing in a relatively safe pool of investment-grade securities. Even if another global recession emerges, odds are default would be fairly rare in this cohort. Bonds in this sector haven't seen quite the influx of money that Treasuries have, so there's a bit more opportunity here.

One inexpensive choice for getting exposure in this arena is PIMCO Investment Grade Corporate Bond ETF (NYSE: CORP  ) . For a reasonable 0.20%, investors can get access to high-quality corporate bonds with a yield of about 3.2%. This corner of the bond market is likely to be the sweet spot in the near future, as it offers higher yields than comparable Treasury bonds without much additional risk.

High-yield bonds
Investors who are willing to take on an even higher degree of risk in their bond portfolio may want to delve into high-yield, or junk, bonds. Yields are a lot juicier in this sector, but default risk is higher, too. High-yield bonds have been getting a lot of attention, and money, from investors in recent quarters, so this sector isn't quite as attractively priced as investment-grade corporates, but there's still some potential here.

If you're willing to venture into junk bond territory, think about using SPDR Barclays Capital High Yield Bond ETF (NYSE: JNK  ) , which will run you 0.40% a year. At last glance, the fund was yielding 7.3%, which is quite an inducement in this low-yield era. However, if economic conditions worsen, bond investors in this sector will likely take a hit. Since risk is elevated here, keep any junk bond allocations to a relatively small portion of your portfolio. Conservative types should bypass the sector altogether.

Emerging markets bonds
Bond investors who want a lot more spice in their portfolio might want to consider emerging markets bonds. As might be expected, risk and volatility are ways of life here. As such, this is another area in which to keep allocations very small. One fund to consider in this asset class is PowerShares Emerging Markets Sovereign Debt ETF (NYSE: PCY  ) , which comes with a 0.50% price of admission and 5.1% trailing yield. Gains and losses can look rather stock-like here, as when the fund lost 19% in 2008 and gained nearly 36% the following year.

Given the current global outlook, emerging markets debt is a very risky place to be. Nonetheless, this area should provide additional diversification and greater long-term return potential for investors who can stomach the inevitable ups and downs.

Ultimately, while the long-term outlook for bonds in the coming years is not promising, many folks will still need a hefty helping of fixed income in their portfolios. While abandoning the bond market shouldn't be an option on the table for any investor, smarter bond investing will be required to sidestep what will likely be subpar returns for much of the fixed-income asset class.

Bonds can help preserve your capital and reduce volatility in your portfolio, but you won't be able to reach your retirement goals on a bond diet alone! Be sure to check out our newest special free report that highlights the shocking truth about your retirement. Don't miss this chance to grab your free copy of this can't-miss report today!

Amanda Kish is the Fool's resident fund advisor for the Rule Your Retirement investment newsletter. Amanda owns shares of iShares Barclays Aggregate Bond ETF. 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 Motley Fool has a disclosure policy.

Read/Post Comments (4) | Recommend This Article (2)

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 July 19, 2012, at 7:47 AM, pondee619 wrote:

    Is there a reason you do not discuss Municipal Bonds. my NJ Fund "Nuveen New Jersey Investment Quality Municipal Fund" NQJ is currently yeilding 5.3% tax free and has been reasonably steady over the past 10 years, save the period of end of 2008 to mid 2009. This seems to fit into your bond scheme outlined above, why no discussion?

  • Report this Comment On July 23, 2012, at 1:44 PM, pondee619 wrote:

    Hello? Anyone home? Any place here where a person can have a question answered?

  • Report this Comment On July 30, 2012, at 8:44 PM, TMFBroadway wrote:

    Sorry for the delay! Muni bonds are a great tool for investors who can benefit from their tax-exempt nature and they are still relatively attractive compared to many other bond sectors. They weren't included in this article simply because I wanted to highlight the sectors that the widest group of investors can utilize -- not everyone should own muni bonds. If you are in a tax bracket where owning munis is advantageous, I think you're in good shape with the fund you mention. Thanks for reading!

  • Report this Comment On August 20, 2012, at 10:33 PM, MHedgeFundTrader wrote:

    The Treasury bond market has just suffered one of the most horrific selloffs in recent memory, taking the yield on ten year paper up from 1.38% to an eye popping 1.83% in weeks, a three month high.

    Yields have just risen by an amazing 38%. This has dragged the principal Treasury bond ETF (TLT) down from $132 to $120. Those who were pining to get into this safe haven at a better entry point now have their chance.

    Rumors for the plunge have been as numerous as bikinis on an Italian beach. Some have pointed to a suspected unwind of China’s massive $1 trillion in Treasury bond holdings. Others point to the incredibly thin summer market trading conditions. Add to that a relentlessly heavy new issue calendar by the government. After all, they have a $1.4 trillion budget deficit to finance this year. That works out to $4 billion a day.

    Long term strategists point to more fundamental reasons. The spread between the ten year yield and the S&P 500 dividend yield is the narrowest in history. Even after the recent slump, equity yields still beat bonds by 20 basis points. This has never happened before. The smarter money began shifting money out of bonds into stocks months ago.

    However, I think that an excellent trading opportunity is setting up here for the brave and the nimble. There is a method to my madness. Here are my reasons:

    *US corporate earnings are slowing at a dramatic pace. Some 40% of those reporting in Q2 delivered revenues misses. They made up the bottom line by firing more people. This is the worst performance since early 2008. Remember how equity ownership worked out after that?

    *The high price of oil is now starting to become a problem and will inflict its own deflationary effects. If we maintain the 24% price hike we have seen in recent months, that will start to present a serious drag on the economy.

    *Fiscal Cliff? Has anyone heard about the fiscal cliff? This 4% drag on GDP growth, another name for a recession, is looming large.

    *Don’t forget that the rest of the world economy is going to hell in a hand basket. The China slowdown continues unabated, and a hard landing is still on the table. Europe is in the toilet. Japan’s growth is on life support.

    *The Chinese aren’t selling. They told me so. They are merely reallocating a larger portion of their monthly cash flow to Europe where yields are a multiple higher. They are doing this because I told them to. This helps support the Euro. Keeping the currency of its largest trading partner strong to preserve exports is in its best interest.

    *QE3? Remember QE3? Even if the Federal Reserve doesn’t implement this expansionary monetary policy, Europe will. And the Fed will probably join in 2013 when we head into the next recession.

    *Paul Ryan for VP? If elected, his death wish for the Federal Reserve will send asset prices everywhere plummeting, including stocks and bonds. Since Romney’s fumbled announcement, Treasury bond yields have soared by 25 basis points.

    There are many ways to play this game. Just pick your poison. The obvious pick here is to buy the (TLT) just over the 200 day moving average at $119. You could buy an October $120-$125 (TLT) call spread in the options market for a quick bounce. If you really want to get clever, you can sell short the $110-$115 call spread, which has a breakeven in terms of the ten year Treasury yield of 2.10%.

    The safe haven trade is not gone for good. It’s just enjoying a brief summer vacation.

    ` The Mad Hedge Fund Trader

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