Bonds and Inflation

Although I’m a huge supporter of investor’s thoroughly understanding the value of bonds, I’m also very skeptical of their investment value over the next 5 years (from August 2012).

I have two primary reasons for my pessimistic outlook.

Interest Rates:
The most basic rule that any bond investor can understand is that the market value of a bond is inversely proportional to interest rates. So to simplify, when interest rates go up, bond prices go down. If interest rates go down, bond prices go up. So understanding this simple rule, we can quickly deduce that bonds are probably the worst investment an invest could find with interest rates at all time lows. I mean where else can interest rates go? That’s right – up! Also remember, the longer the maturity, the greater impact interest rates have on the bond’s value.

One of the first things that any bond investor must understand is that inflation is like a toxic fluid that removes any trace of yield. For example, if your bond has a 5% coupon and the economy experiences 4% inflation, your gain is only 1%. Talk about a ruff return! As we look to the projection of future inflationary periods, we can quickly conclude that scary-inflation is on the horizon. Why? Have you seen our country’s debt? That’s why. You see, inflation is nothing more than a simple form of taxation. Although no one ever looks at it that way, that’s all it is. I’m sure the FED will provide sugar-coated inflationary purposes with menial metrics, but never forget, inflation indirectly produces billions in revenue for the federal government every year.

So how can you avoid poring this inflationary acid all over your investments? Well avoid bonds when yields are low. A great way to determine when bonds are high or low is a simple comparison of the 10 year federal note and the S&P 500’s dividend yield. Investing mogul, Peter Lynch, recommends switching to a bond position when the federal note’s return exceeds the S&P’s average dividend yield by 6%. What great advice! My personal opinion why Lynch recommends 6% is twofold. First, Lynch knows that inflation typically runs around 4% annually. Second, Lynch knows that most bulky fortune 500 companies might only grow their equity on average at a meager 2% annually while paying a decent dividend. When these two figures are combined (6%), he’s conservatively accounting for the risk associated with switching to a debt based instrument.

Although many investors look to bonds as a super secure means to invest, I’d actually argue the exact opposite. I think bonds are a great place to put your money, but the market has to be in the right position and at the right time. The key things to look for when investing in fixed income securities is high interest rates on federal bonds and high P/E’s ratio’s across the entire market. When in doubt, exercise Lynch’s rule of thumb.