Even hibernating bears know that bonds have essentially been dead money over the last year, or so. Interest rates are ridiculously low and not likely to improve any time soon given the anemic U.S. economy and European financial concerns. What's done is done, so what should we expect to earn from bonds in the future? Consider these two scenarios:
Best Case Scenario
Interest rates and the price of bonds will remain steady. Although this is the best case scenario, it is quite ugly. Consider the 12/15/2011 Treasury Yields: 1 mo. 0.0%, 3 mo. 0.0%, 6 mo. 0.05%, 1 yr. 0.12%, 2 yr. 0.26%, 3 yr. 0.37%, 5 yr 0.86%, 7 yr 1.38%, 10 yr 1.92%, 20 yr 2.60% and 30 yr 2.92%.
Do you really want to commit your money for seven years just to break the 1% threshold, or 20 years to break the 2% threshold. Sure the money is guaranteed by the full faith and trust of the U.S. government, but inflation is eroding your spending power each day money is held at these yields.
Worse Case Scenario
Interest rates will rise at some point in the future, but is that a good thing for income investors holding bonds? The price of a bond has an inverse relationship with interest rates. That is, when interest rates rise, the price of bonds goes down and when interest rates drop, bond prices increase.
With short-term bond interest rates hovering around 0%, its not difficult to determine the direction of the next major move. If you buy a bond for $100 paying 1% and interest rates move to 3%, the bond's price will have to fall to $33 to provide the market's 3% return ($1/$33 = 3%). Even a modest increase to 1.5% will erode your bond price a third to $66.
These are simple examples. The real price erosion will be heavily influenced by the remaining term of the bond. The longer the term, the more price erosion.
So, what's an income investor to do?
Bond Alternatives
Over the next several months, I plan to reduce my bond allocation and purchase quality blue-chip dividend stocks that are yielding in excess of my bond holdings. Consider these dividend growth stocks that have a current yield equal to or greater than the 2.60% yield on 20 Year U.S.