Every time stocks take a hit (and sometimes even when they don't), someone in our Start Investing community asks this question: Is it time to buy bonds? Or better yet: When is the right time to buy bonds?
Some investors believe bonds always belong in a portfolio. I'm not one of them. Unless you need income from your portfolio, I think you can get along fine with a mixture of stocks and cash.
But there comes a time when speculators look at bonds: when interest rates are about to head down. (My husband is a speculator, and he says this time is coming.) Falling interest rates mean a rally in the bond market.
No one knows when interest rates will fall. But we can get some clues by looking at the yield curve. In a column last month,
3 Ways to Ride Out a Volatile Market, I fretted about the nearly inverted yield curve, calling it a financial Death Star hanging over the economy.
quickly posted a message in our Start Investing community suggesting that I didn't know what I was talking about -- in a friendly way, of course.
Then Tim Middleton, our mutual-funds columnist, jumped on the bandwagon. And Tom Woodruff, a Ph.D. economist who is also co-host of the
Money Central Radio News Hour
, added that he, too, was forced to part company with me on this one. OK guys, I get the message. But I think you're wrong.
Why the Yield Curve Matters
For support, I called Craig Henderson, a math wizard who happens to be a municipal bond manager in Chicago. He's able to talk about bonds in a way that I can make sense of. And Henderson told me that municipal bonds are incredibly attractive right now. But more about that later.
The yield curve is a line that stretches from the rates charged for short-term loans in the money market through medium-term loans, like 10-year bonds issued by the U.S. Treasury, to long-term loans, like the 30-year bonds issued by corporations. Picture the short-term loans on the left, medium in the middle, long-term loans on the right. The normal condition of the yield curve is an upward slope, with short-term rates lowest and long-term rates highest. That makes sense because investors expect to get a higher interest rate for taking on the risk of investing their money for 30 years rather than for 30 days.
What we have now, though, is a humped curve, with the middle higher than either end. In my earlier column, I said that the long end was being tugged down because the market expects a recession.
Treasury is Buying Bonds
My friends Jim, Tim and Tom disagree. They believe the long end of the market is pulled down because the United States has a budget surplus right now and the Treasury is buying back bonds. My colleagues argue that the buyback program has resulted in a shortage of long bonds and a rally in the long end of the market.
I say baloney: True, the Treasury is buying back bonds. But we don't know how much that impacts the yield curve. Outstanding government bonds total something like $3 trillion. Let's say the Treasury is buying back $30 billion this year. That's small potatoes. Besides, whatever caused it, it's still an inverted yield curve, and that implies certain consequences.
Henderson agrees with me, which is one reason I like him, of course. He says that if the yield curve were steep out to 20 years and then dropped off precipitously, he would buy the argument that the buyback program inverted the curve.
But in fact, early this week the two-year Treasury was yielding 6.85%; the five-year, 6.81%; the 10-year, 6.56%; and the 30-year, 6.24%. "So when you see that the 10-year is inverted compared to the five-year, I don't buy the argument that the yield curve is inverted because the Treasury is buying long bonds back," he says.
A Good Time for Long Bonds?
But let's get to the point. Is this a good time to buy long bonds? Or, as someone in the Start Investing community asked last week, is it a good time to buy zero-coupon bonds?
A zero bond pays no interest. It is sold at a discount and appreciates to face value. If you believe interest rates will drop and bonds will rally, you will get more bang for your buck with a zero.
Henderson suggests you hold on to your cash. When the yield curve is inverted, it does mean long rates will go down, Henderson says. So will short rates -- the whole yield curve will go down. When that happens, it will be a good time to own bonds.
But it might be inverted for a long time before that happens. Henderson says the shortest time the yield curve has been inverted is nine months. (And it is not fully inverted yet.) The longest is two years. And during that time, rates might go higher. "There have been times when long rates went 200 or 300
basis points higher before they ultimately went lower," Henderson says. "But the curve was inverted for the entire time."
Rates will not head down until the economy has slowed, until people stop building houses and start losing jobs. That's what it takes. And that's what the
is trying to effect by raising the short rates it controls.
Economy Remains Too Robust
Henderson thinks we're in for a few more, perhaps several more, short-term rate hikes. The recent inflation and employment figures confirm that the economy is robust -- too robust, according to the Fed governors, who worry about inflation.
It's pretty clear that we've got wage inflation. It costs more to employ a worker now than it did a year ago, maybe not in base compensation, but in stock options, hiring bonuses and the like.
"The economy is booming," Henderson says. "I see my wife spending money and redecorating like we're in a bull market. And if you don't have a job now, you're probably not employable."
Henderson thinks the yield curve will stay inverted and both short-term and long-term interest rates will go higher before they go lower. That is not a good time to buy bonds. But this time there is one exception: municipal bonds, which are free of federal taxes and free of local taxes if you purchase them in your own state.
Municipal Bonds Still Look Attractive
Municipal bonds have their own yield curve, which is flat but not inverted. One-year bonds yielded 4.5% early this week; two-year, 4.76%; 10-year, 5.20 %; and 30-year, 5.81%. When you compare them with Treasury bonds, munis are more attractive at every maturity.
To figure the tax-equivalent yield of a muni bond, you take 1 minus your tax rate, and divide the bond's yield by the result. So, for example, if you are in the highest tax bracket, which is 39.6%, a two-year muni bond yielding 4.76% would have a tax-equivalent yield of 7.88% -- 4.76% divided by 0.604. That is 103 basis points over the two-year Treasury, which yields 6.85%.
The 10-year municipal bond, which yields 5.20%, has a tax-equivalent yield of 8.61% -- 205 basis points over Treasuries. And the 30-year muni, yielding 5.81%, has a tax equivalent yield of 9.62%, 338 basis points over Treasuries.
The time's not yet right for long Treasury bonds. But Henderson says there's been only one other time in his 25 years in the bond market -- the final quarter of 1986 -- when munis were attractive in comparison with Treasuries.
Follow Mary's Start Investing Portfolio at MoneyCentral.
Mary Rowland is the Start Investing columnist for MSN MoneyCentral. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Rowland welcomes your feedback at
Rowland's Start Investing Portfolio