#1: Buy Bonds
Yes. I realize fully that bonds are the most hated asset class in the world right now. As in totally despised. And that is precisely what makes them a good hedge at the moment.
There is a general and widespread belief that the Fed’s tapering plans automatically mean higher bond yields. All else equal, it would. But in the world of investments, “all else equal” conditions rarely hold.
As I wrote in December, demand for U.S. bonds from foreign institutional investors has recently been at its highest levels since 2000. And at the same time, the growth rate in the supply of new Treasuries has been dramatically slowing due to the shrinking of the U.S. budget deficit.
But more fundamentally, it is difficult for me to see bond yields rising significantly in a prolonged period of low inflation. The U.S. economy does indeed appear to be growing again at a decent (though far from spectacular) clip. But that growth has not come at the cost of inflation, which is still limping along at a 1.2% rate. And I expect to see inflation stay muted for a long time due to lower energy prices — a product of the domestic energy revolution — and slower debt accumulation due to the pending retirement of the baby boomers.
As I’m writing this article, the yield on the 10-year Treasury is a hair shy of 3%. That is not a high enough yield for me to consider bonds a good investment. But at these yields, I do see bonds as a great hedge.
And I’m not alone. Jeff Gundlach — considered by many to be the sharpest fixed-income manager in the business — commented in a recent Barron’s interview that he could see yields falling to new all-time lows. That might be too extreme; only time will tell. But in my view, the “correct” bond yield given the lack of inflation and the overall hunger for yield from retiring boomers is somewhere in the ballpark of 2.5%.