The U.S. Government Bond Bubble (And What To Do About It)

Treasury bond prices will likely suffer a major decline in the next few years. Here are eight high-yielding stocks that are a smarter alternative for the income part of your portfolio.

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The Federal Reserve has pumped a massive amount of money into the U.S. economy since 2008.

America’s finances are deteriorating. The Federal debt has increased by more than 50% over the past three years. New liabilities in 2011 totaled $1.3 trillion. And there is no prospect of a quick fix that would bring this snowballing debt under control. As a result, rating agencies have warned that the U.S. credit rating is at risk of a downgrade.

Nonetheless, U.S. Government bonds have been in a major bull market – some analysts are even calling it a bond bubble. Indeed, just as easy money produced a boom in technology stocks in the late 1990s and a housing bubble six or seven years later, a similar boom-and-bust cycle now appears to be under way for government bonds. Prices of long-term Treasuries are up as much as 30% since early this year. Why have such big gains occurred at a time when the finances of the U.S. government are getting so much worse? There are three reasons:

Extremely stimulative Fed policy. Ever since the banking crisis in 2008, the Federal Reserve has been pumping massive amounts of money into the U.S. economy. As a result, interest rates on 10-year Treasury bonds have dropped from 3.9% in 2010 to around 2% today. And since bond prices rise as interest rates fall, Fed policy alone would be enough to create a bond boom.

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Diminished demand for borrowing. Businesses have little need to invest and expand when business is so slow. In fact, many companies are sitting on large cash hoards, waiting for a sustainable recovery. And although consumers might like to borrow more, their actual demand for loans has been reduced by the difficulty of getting credit approval. As a result, outstanding consumer debt is lower today than it was before the 2008 banking crisis, and so is mortgage debt.
Flight to safety. The third reason for the boom in U.S. government bonds may be a little counterintuitive. It’s the global debt crisis. Although the outlook for the U.S. is bad, the situation in Europe is even worse, because of the troubles of the euro, the common European currency. International investors want to reduce their exposure to the Eurozone, but don’t have many places to move their money. Switzerland, Japan and the U.K. are all attracting some of this hot money. But the U.S. remains the world’s biggest safe haven (at least least until our finances deteriorate further).

None of these trends will support today’s lofty bond prices indefinitely. The Fed has reduced interest rates as much as it can. If it continues to pump money into the system, the eventual result will be higher inflation (which is already up to an annual rate of 3.4%, compared with 1.1% a year ago). So either because of a turnaround in Fed policy or an increase in inflation pressures, the trend in future interest rates will be upward sooner or later. At some point, demand for borrowing will increase after the economy has begun a sustained recovery – and that will put additional upward pressure on interest rates.

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The continued flight of hot money into U.S. bonds depends almost entirely on what happens in Europe. But whether the Eurozone breaks apart or stabilizes (perhaps after a couple of countries have been forced out), the flow of hot money will eventually taper off. Perhaps it will even reverse, since a stable Eurozone built around Germany would have better financials than the U.S. does.

The bottom line is that the return of Treasury bond yields to where they were less than a year ago is entirely likely within the next few years. And it would mean losses of at least 20% on many U.S. government issues.

Why would investors continue to rely on such securities, especially now that the yields offered are minimal? Two reasons: First, conservative investors typically need to keep a chunk of their money in income investments rather than putting it all into the stock market. (And there aren’t a lot of available choices for income besides bond funds in many tax-deferred retirement accounts.) Second, U.S. government bonds and the funds that hold them seem extremely safe because the government can always borrow, tax or print money to pay off the debt.

That protection is only against default, however, not against losses resulting from falling prices. And the likelihood of a price decline argues strongly against bonds. As an alternative way of meeting your need for income, it’s worth considering high-quality stocks with yields of more than 3% and long histories of dividend increases, or looking for income- or value-oriented funds that hold such shares.

High-yielding stocks are now paying far more than government bonds and do raise their dividends over time, whereas bond payouts are usually fixed. That provides some degree of protection against an uptick in inflation. Moreover, big high-yielding stocks have been outperforming the rest of the market this year.

Among the shares worth considering are most top-rated electric utilities. But you should balance utilities with other types of companies. Stocks that meet the criteria include: Abbott Laboratories (3.4% yield); AT&T (5.9%); Illinois Tool Works (3.1%); Johnson & Johnson (3.5%); Kimberly-Clark (3.8%); Pepsico (3.1%); Procter & Gamble (3.2%); and Sysco (3.7%).

Of course, you shouldn’t put all of your money into equities, not even conservative shares. Stock prices would suffer if a crisis in Europe or a global recession occurs next year. But historical patterns suggest that the long-term outlook for stocks is a lot better than that for bonds. In contrast to bond prices, the Dow is just 12% higher today than it was 12 years ago – a gain of only 1% a year. And historically, after such a long period of nearly flat performance, stocks have eventually enjoyed a multi-year advance. The best strategy at this point is to favor high-yield stocks over bonds and then keep more money than usual in cash if you need to manage down your risk level.

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