Bonds and Inflation

While I’m a big believer in investors’ thorough understanding of the value of bonds, I’m also very skeptical about their investment value over the next 5 years (as of August 2012).

I have two main reasons for my pessimism.

Interest charges:

The most basic rule that any bond investor can understand is that the market value of a bond is inversely proportional to interest rates. Put simply, when interest rates rise, bond prices fall. When interest rates fall, bond prices rise. So if we understand this simple rule, we can quickly deduce that bonds are probably the worst asset to invest in when interest rates are at all-time lows. I mean, where else can the interest go? That’s right – on! Also, remember that the longer the term, the greater the impact of interest rates on the value of the bond.

Inflation:

One of the first things any bond investor needs to understand is that inflation is like a toxic liquid that eliminates any trace of yield. For example, if your bond has a 5% coupon and the economy experiences 4% inflation, your gain is only 1%. Talk about a Ruff return! If we look at the projection of future periods of inflation, we can quickly conclude that scary inflation is on the horizon. Why? Have you seen our country’s debt? That’s why. You see, inflation is nothing more than a simple form of taxation. Even if nobody ever sees it that way, but that’s all. I’m sure the Fed will deliver sugar-sweet low-ratio inflation purposes, but never forget that inflation indirectly generates billions in revenue for the federal government every year.

So how can you avoid spreading this inflationary acid across your investments? Avoid bonds when yields are low. A good way to tell when bonds are high or low is a simple comparison of the 10-year Bund and the S&P 500 dividend yield. Investment mogul Peter Lynch recommends switching to a bond position when the Bund yield is the average dividend yield of the S&P by 6%. What great advice! My personal take on why Lynch recommends 6% is twofold. First, Lynch knows that inflation is typically around 4% annually. Second, Lynch knows that most large Fortune 500 companies grow their equity by a meager 2% per year, on average, while paying a decent dividend. When these two numbers are combined (6%), he conservatively accounts for the risk involved in switching to a debt-based instrument.


Although many investors see bonds as a super safe investment, I would argue the exact opposite. I think bonds are a great place to put your money, but the market needs to be in the right position at the right time. The main things to look for when investing in fixed income securities are high interest rates on Bunds and high P/E ratios across the market. When in doubt, refer to Lynch’s Rule of Thumb.