The Death of Bonds?

As the bear market crushed investors' stock portfolios, many people turned to Treasury bonds for safety, security, and protection from losses. But as the returns on those bonds this year clearly show, you definitely shouldn't trick yourself into thinking that Treasuries are immune from potentially huge losses.

Is the Treasury bubble bursting?
After reaching low yields late last year around 2.5%, rates on 30-year Treasury bonds have skyrocketed in the first five months of 2009. On Wednesday, the long bond closed with a yield of about 4.6%, the highest since last summer.

When bond yields rise, the prices of existing bonds go down. As an example, one ETF that tracks long-term Treasury bonds maturing in 20 years or more has dropped over 23% since the beginning of January. A similar intermediate-term Treasury ETF, which is typically less vulnerable to big fluctuations in rates, has still dropped 7.6% since the year started. And those returns include the interest payments that investors have received on their bonds.

What's going on?
Turbulence in the bond markets is coming from a number of different sources. On the fundamental side, higher budget deficits and government spending are forcing the Treasury to issue more bonds, increasing supply and driving yields higher.

At the same time, though, the Federal Reserve has taken steps to try to keep bond yields low. Because long-term bond rates have an impact on mortgage rates and other key interest rates for borrowers, keeping long rates low helps those trying to refinance mortgages and keep debt payments under control. Although the Fed typically controls only short-term rates, its efforts at quantitative easing have involved direct purchases of Treasuries and other long-term bonds in order to push rates lower.

Yet from the market's recent moves, it's clear that quantitative easing is no longer working to prop up bond prices. Spreads between inflation-indexed bonds and other Treasuries show increasing concern about future inflation, which is the biggest threat to bond investors.

In other words, the bond market isn't nearly as safe as many people thought it was. And after a bull market in bonds that has pushed their returns over those of stocks over the past 40 years, a reversal of fortune could well last for decades.

Why you can't bail on stocks
The fact that bonds can be just as volatile as stocks is a major reason why you should keep a diversified portfolio that includes at least some stocks, no matter how risk-averse you are. Not only can stocks add to your overall expected return, but they can do so while reducing the overall volatility of your portfolio.

To illustrate that point, consider how a number of dividend-paying stocks have performed so far in 2009:

Source: Yahoo! Finance, Morningstar.

For investors owning a mix of bonds and stocks, rising share prices have helped to offset some of their bond losses.

Now, clearly that diversification can also hurt you when stock prices fall. During 2008, for example, those holding 100% of their money in long-term Treasuries did very well. But as the performance of bonds and stocks both swing back and forth, returns over the long haul have tended to favor stocks historically over most periods of time. And while while someone with an all-bond portfolio might be able to ignore bad news in the stock market, owning just bonds leaves you open to other risks, such as inflation.

Whether you're investing for the long haul or need income now from your portfolio, both bonds and stocks play valuable roles. You shouldn't give up on bonds entirely, but neither should you rely on them to support you without help from other investments.

For more on investing for income, read about:

• Should you be back into stocks?
• Seven stocks for those who're just starting out.
• Here's the one investment to buy today.