10/25/12 11:56 AM – Bull Market in Bonds Over?

Since 1982 bonds have been in a long, strong bull market, coinciding with the stock bull market until 2000 and outperforming stocks since. In fact, from 1982 long-term treasury bonds returned over 11% per year, within a fraction of the return on stocks but with far, far less volatility.

For that reason, investors have been flocking to bonds since 2009 and generally taking that money from stocks.

Now that that 10-year treasury bond yields 1.8% and the 30-year yields 2.93%, both lower than the average inflation rate over the last 50 years, it seems we are close to an end to the long-term drop in interest rates that has fuled the bond boom.

Some argue that if the world economy stays punk or gets worse US bonds will stay strong and may even drop more.

Maybe, but consider this: the US is piling up debt fast and will continue to do so even if the economy strenghtens. The US spends its entire tax income on transfer payments (entitlements) and borrows everything else it spends. Put another way, the US federal government could shut down every single department except Medicare, Medicaid, Social Security and the other entitlements and doing so would mean that it would only break even. Right now, entitlements are 2/3 of the budget and growing rapidly while all other departments are 1/3.

Moody’s has threatened to drop the US credit rating another notch or two if the so-called fiscal cliff isn’t somehow reversed.

Well, it can’t be. Only the form can change, if it does at all, no matter who is elected in less than two weeks. The fact is, the US already has so much debt currently, it equals the size of the whole economy! That’s what it means to have a debt to GDP ratio of 100%.

More downgrades of US credit may be forthcoming over the next year or two and that probably means higher interest rates, regardless of whether the economy recovers.

As the US credit rating declines, the big demand for US treasuries should drop as well. The concept of over-indebted and getting more so at a rapid pace and that of being a safe haven are imcompatible.

Bottom line: Think about how much money you want tied up at 2% or 3% interest. Depending on the maturity of your bonds, it may not take much of a drop in the bond market to start giving you negative returns in bonds.

If you like, we can talk about alternatives to bonds and about the kinds of income investments that will do best.