Bond Yields Approach Zero But Risk Looms

Last Updated Sep 12, 2011 10:39 AM EDT

As stocks look to have a fifth month in a row of declines, investors are searching for the safety of the recently S&P downgraded US Treasuries. This trend is driving the already record low rates even lower. Here's my take on what's going on and what you should consider doing.

Today, you can get whopping 0.16 percent annual return on a two year Treasury. That means for every $100 you invest, you can earn 32 cents interest over a two year period. Don't spend it all at once. If you want to take some risk and bet against inflation, you can earn a whole 1.91 percent on a 10 year treasury. These rates are now at a 60 year low, as my colleague Conrad deAnelle points out.

Betting on a bond bubble hasn't worked
For the past few years, experts have been predicting a bond bubble. As my colleague Nathan Hale pointed out, even PIMCO's legendary Bill Gross made a huge mistake betting against Treasury bonds. And just as Wells Fargo's chief economist John Silvia declared that rates would definitely rise, rates plummeted. Staying in a money market seemed safe but missed out on great bond returns.

Quality bond funds have been on fire. Over the past five years, the Vanguard Intermediate-Term Bond fund (VFIUX) has earned an average of eight percent annually over the past five years.

Is the bond bubble threat over?
The Federal Reserve has signaled that it will keep rates low for the next two years. Many people mistakenly think that this means there will be no bond bubble for at least the next couple of years. I couldn't disagree more. Remember that the Federal reserve only controls short-term rates, essentially one day. Markets control intermediate and long-term rates.

While I'm smart enough to know not to predict interest rates, I understand math enough to make a bold prediction - Treasury bonds can't perform as well overt the next year as they have averaged over the past five. The Vanguard Intermediate-term bond fund mentioned above is now yielding 1.01 percent. Its duration is 5.2 years, which means that a one percent change in rates translates to an estimated 5.2 percent change in the funds value. In other words, if rates fell to zero, the bond fund would increase by 5.25 percent. Add another 1.01 percent from the yield and you get an estimated 6.26 percent return. That's less than the eight percent average over the past five years.

Now I'm making an assumption that rates won't turn negative on a nominal basis. If you disagree, please send me $100 and I'll promise to pay you back $99 a year later. The point is that there is now very little upside on bonds from rates declining further. While I'm not predicting rising rates, that possibility is real and the impact on bonds could be severe. Scary as this possibility is, I actually have relatively little to fear, as I'll now explain.

What to do now
It would seem that there is no solution on how to earn great rates without taking much risk, but those who have read my work know the answer is easy. Smaller investors can find certificates of deposits that pay intermediate to long-term rates that have very easy early withdrawal penalties. Ally Bank has a five year CD that pays 2.14 percent, and has a 60 day early withdrawal penalty. That's equivalent to having the right to sell it back to them at only a 0.36 percent discount.

And this week, I opened another seven year CD at Security Service Federal Credit Union paying 3.50 percent and having only a one year penalty. Thus, I earn 3.5 times the Vanguard Intermediate-Term Treasury and have less risk since I can always take the penalty and lose a maximum of 3.50 percent. The Vanguard fund could lose over 10 percent if rates increased by two percent. Unfortunately, many people don't qualify for membership to this credit union.

My advice
The attractive bond returns of the past have little room to continue. The upside is now very limited and the downside is huge. Consider CDs with great rates and early withdrawal penalties. Though sure to read the fine print on the penalties, and always stay below FDIC and NCUA insurance limits. The best single place to find great CDs is DepositAccounts.com. They also sometimes discuss this strategy.

Rarely in investing can you earn higher rates with less risk.
More on MoneyWatch
Best CD - Better Than Bonds
Where to Stash Your Cash
Rates - How Low Can They Go?
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    Allan S. Roth is the founder of Wealth Logic, an hourly based financial planning and investment advisory firm that advises clients with portfolios ranging from $10,000 to over $50 million. The author of How a Second Grader Beats Wall Street, Roth teaches investments and behavioral finance at the University of Denver and is a frequent speaker. He is required by law to note that his columns are not meant as specific investment advice, since any advice of that sort would need to take into account such things as each reader's willingness and need to take risk. His columns will specifically avoid the foolishness of predicting the next hot stock or what the stock market will do next month.

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