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What Do You Do When Your Bonds Give Nothing Back? Don't 'Chase Yield'

NEW YORK (TheStreet) -- Most long-term investors own bonds or bond funds, hoping they'll provide some safety and perhaps do well when stocks don't. But bond investors have been living on faith in recent years due to low yields and the picture isn't getting brighter.

Yields on long-term bonds have continued to fall this year while short-term yields have held pretty steady. That's what experts call a "flattening of the yield curve," and it signals poor bond returns coming. Long-term bonds pay higher yields because investors tie their money up longer, taking on greater risks. When the curve gets flatter, that risk premium gets smaller.

The culprit is slow economic growth around the world. Since the end of the last recession, the U.S. economy has grown by only about 2.3% a year, compared with 3.3% in the prior 10 years. Inflation is running around 1%, half the Federal Reserve's 2% target. Low inflation sparks concerns about three possibilities, according to Morningstar, the market-data firm:

"Deflation is a sustained fall in the general price level of goods and services, while disinflation occurs when the inflation rate is positive but declining. Lowflation refers to an inflation level that's consistently lower than the rate targeted by monetary policymakers."

When prices fall, for example, consumers postpone purchases and businesses avoid investment, undermining economic growth. Falling prices are especially bad for borrowers, because their debts and payments remain the same while their incomes may get smaller.

Trying to spur economic growth, central banks such as the Federal Reserve have kept short-term rates near zero. Now fears of deflation, disinflation and lowflation are causing long-term rates to fall. Since the start of the year, the yield on the 30-year U.S. Treasury bond has fallen by nearly half a percentage point, or 49 basis points, while yields on two-year Treasuries have fallen only three basis points.

For bond investors, these conditions are the worst of all worlds. Low yields stunt interest earnings. And bonds themselves could lose value when yields eventually rise, since investors won't pay full price for older bonds that pay less interest than new bonds.

So what's a bond investor to do?

Morningstar warns against "chasing yield," or pouring money into riskier types of bonds, such as high-yield bonds, to get slightly higher interest payments. Because other investors have already done that, prices of these bonds are now pretty high -- poised to fall if rates rise.

A standard laddering strategy makes sense, Morningstar says, though long-term investors should not count on great returns. Laddering means owning a variety of bonds across the spectrum from short to medium to long maturities. Those with shorter maturities are safe but pay very little, while those with longer maturities pay a little more interest but lose more value of prevailing rates rise.

Another alternative, though not mentioned by Morningstar, is to reduce bond holdings and put cash into federally insured bank savings. You won't earn much, but you'll be protected against loss -- and you wouldn't earn much in bonds anyway. And you could get at your cash quickly if conditions improve and you see promising investment alternatives -- in bonds or elsewhere.

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