Mapping Out a Course for Bonds

November was a crazy month for bond prices. They soared on the Treasury's Oct. 31 announcement that it would stop issuing the 30-year bond, and they then endured a sharp selloff that pushed yields well above the levels from which they started their journey.

Where do yields go from here, and what kind of returns can investors expect from bonds now? Let's look at two major factors that pushed yields up: indications that the economy is better than most had expected, and bond investors' mind-set.

Consumer spending isn't shaping up to be the disaster that many investors had feared after Sept. 11. Auto companies began by offering 0% financing, which spurred a jump in sales. Although these sales aren't particularly profitable for Ford (F Quote), General Motors (GM Quote) and DaimlerChrysler (DCX Quote), they indicated that consumers were willing to spend at certain price levels.

Questions about declining air travel's impact on the economy are also being partly answered. While some people are taking alternative means of transportation, others who aren't traveling for pleasure seem to be spending some of that savings. This bears out the motto of one of my mentors: If American consumers have it, they'll spend it. So the impact of reduced air travel on gross domestic product looks like it'll be less than the negative 0.5% to 1% that I'd expected.

Therefore, it makes sense that bond yields have risen. I have noted the positive impact that falling mortgage rates (which are determined by bond prices) have on spending through increased refinancing activity. Now that bond and mortgage yields have risen to make refinancing unattractive, consumer spending will have a tough time accelerating much further.

But I have shown in the past that the major problem with the economy lies not in the consumer sector, but in the business sector.

Bond yields not only react to what the economy is doing, but help shape what the economy does. Given that corporate bond yields have not declined much this year, while expected inflation has declined, the real cost of new capital investment has risen this year. This higher cost of capital will make it harder for the economy to sharply accelerate.

It should be noted that many institutional bond investors feel that the economy is about to turn up sharply, and they are ready to push bond yields up. But they have felt this way all year, and they have been wrong. I think a major reason is that long rates have stayed high, inhibiting growth.

I continue to think that different ends of the yield curve are priced for different outcomes. I still don't like the risk/return tradeoff of shorter bonds, but I think the longer end offers some value. I cut my long Treasury exposure into the rally and then added some corporate exposure as the bond market sold off. Bond prices have rallied a bit over the last week, then gave back nearly all of those gains Wednesday, so I'm not adding more for now. I think a further selloff would be a buying opportunity, as it would further limit how fast the economy could grow. If bond prices move significantly higher, I would become a seller again.