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Time to Sell Bonds and Bond Funds?

Heed the red flags in an overheated bond market

   

Time to Sell Bonds and Bond Funds?

In his famous hit song titled “The Gambler,” Kenny Rogers explains you got to “know when to hold ‘em and know when to fold ‘em.” But knowing the ideal time to exit a game of cards or a trade or an investment is something everyone would like to know, not just gamblers.  So given the fact that bond prices have surged and yields are slim, is it time to ditch bonds?

Demand Grows for Low-Yielding Investments

Earlier in the week the U.S. government had no problem selling $36 billion in two-year Treasury notes. The fact that these Treasurys are yielding just 0.441% didn’t seem to faze buyers either. Low yields or not, they’re piling in. And so long as the U.S. government can obtain cheap financing from eager buyers of its debt, it can continue running up multi-trillion dollar deficits without incident. 

Short-term government bond ETFs (NYSE: SHY) with maturities between one and three years have a 30-day SEC yield of just 0.35%. Long-term Treasury ETFs (NYSE: TLT) are yielding around 3.44%. The SEC’s yield calculation takes into account the interest earned during the most recent 30-day period after deducting the fund’s expenses.  

The mentality of today’s bond investor has pushed aside the traditional view of investing in bonds for yield income. This former viewpoint has been replaced by investing in bonds for capital protection.

Is lending your money to a fiscally drunk institution at 0.441% the best use of capital? Regardless of your answer, the perception of U.S. Treasurys as “safe investments” continues to comfort the people buying them.

A Debt Seller’s Market

Today’s bond market favors debt sellers, not the buyers. Knowing this, U.S. corporations (NYSE: LQD) and the government alike have been issuing new debt in the form of bonds at a record pace.

Around $332 billion in corporate debt has been issued during the third quarter alone. Even companies with a spotty credit history are having an easy time finding buyers for their debt. As borrowing rates have cratered, prices for junk bonds (NYSE: HYG) over the past year have soared 21.50%.

Moody’s Investors Service estimates the default rate on high-risk U.S. corporate bonds will decline below 3% by year’s end. The default rate tracks the percentage of companies with junk-rated debt that missed bond payments during the preceding 12-month period. Last fall, the default rate was at 14.60%.

Even with today’s lower default rates, the corporate borrowing binge will eventually have a cost. All of the record debt that companies are racking up today will have to be paid. And as Warren Buffett once quipped, “Debt is a four-letter word.” 

What To Do?

 
There are many warning signs in today’s overheated bond market. Record low yields favor debt sellers, not debt buyers. Also, increasing debt loads for both corporations and the government will come back to bite them (and the individuals that financed them) once the current cycle of over-borrowing fizzles out. No doubt, most of Wall Street’s credit analysts and bond underwriters are still forecasting blue skies ahead. Should we expect anything less?

If you’ve owned a bond fund or ETF (NYSE: AGG) and enjoyed the run-up, what should you do? If bonds have suddenly become a disproportionately large part of your portfolio now is probably a good time to rebalance your bond investments back to their original target allocation.

On the other hand, if you’ve missed the great bond bull market, feel free to jump in. But just make sure you understand the party may be short-lived. And even if it’s not, its eventual conclusion won’t be pretty. Here’s to hoping you’re not there when it happens. Or as an old financial planner once told me: “I don’t mind losing money I just don’t want to be there when it happens.”  

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Article printed from InvestorPlace Media, http://investorplace.com/2010/09/time-to-sell-bonds-and-bond-funds/.

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