Deflation: How low will they go? | The Economist

I was going to write about the appeal of utility stocks today*.

However, based on what I'm hearing from my clients, I think I better go back to the bond market.

When I returned to the office yesterday, I had about a dozen messages waiting. All of the subsequent discussions focused on interest rates, income needs, or some variation on the same theme: low interest rates are brutal on investors.

At this writing, 10-year Treasurys are yielding slightly more than 2.5%. Any Treasury note maturing in under 2 years yields less than 1/2%.

Put another way, if you invest $100 today in a Treasury that matures in August, 2012, you will have about $1 more than you have today - in two years.

So: are bonds still a good investment?

To me, you have to start with bond investment basics. Even in "normal" times, all any bond investor should expect is to get interest paid every 6 months and principal back at maturity.

Bonds can play a very useful role in a balanced portfolio since they can even out any equity market swings, so from both an income and capital preservation perspective bonds continue to be attractive.

On the other hand, with yields so low, it's hard to get rich buying high quality bonds these days, especially in the shorter maturity area.

In my opinion, the best investment opportunity in fixed income today can be found in the lower rated municipal bond arena, where yields are still pretty high. However, this assumes that you have a decent credit analyst picking the bonds and can handle less liquidity.

In addition, based on my client feedback, most investors are pretty skittish about municipal finances, and are not eager to buy even general obligation bonds.

This morning's Economist magazine blog has a pretty good post on the bond market. The most interesting quote from HSBC economist Steven King:

I'm inclined to think that bond yields are appropriately low at the moment and, indeed, might fall further. I accept that fiscal positions are terrible but, as with Japan, that proves nothing. Yields are likely to remain low because (i) aging populations will shift their investments out of assets delivering capital growth into those that deliver a steady income stream (ii) productive potential growth was overstated in recent years and, as perceptions drop, real yields will end up lower (iii) related to this, cash rich companies bereft of interesting investment ideas will be under pressure to return cash to their shareholders (iv) in a deleveraging world, deflation is more likely than inflation (v) in a bid to avoid deflation, central banks will be forced to expand their balance sheet holdings of government debt.

I said a couple of weeks ago that I thought interest rates might move higher in the short term only because we have had such a strong bond market rally since the end of the first quarter. I still think this might happen, although I obviously missed the most recent interest rate leg downward.

From a longer term perspective, I am inclined to agree with Mr. King: interest rates are low for lots of reasons, and will stay that way until we are able to wring the excesses out of the global economic system.


Deflation: How low will they go? | The Economist



*I think that regulated utilities that yield more than 5% offer a compelling alternative to corporate bonds, albeit with some capital risk.