Interest rates have just about reached their theoretical limit. As of this writing, the most lucrative one-year certificate of deposit available pays 1.1%. Thirty-year mortgages are at around 3.62%, and dropping. Money is cheap right now.
SEE: Understanding interest Rates, Inflation And The Bond Market
State of the Bond Market
So it's a buyer's market for money, or at least a borrower's one. However, downward pressure on interest rates means that finding an investment with a healthy return is a correspondingly more difficult task. The S&P 500 is relatively unchanged from four years ago, and people are holding stocks only with the greatest of trepidation and uncertainty.
This leaves the question of bonds - stocks' staid and demure counterpart. If people can borrow money so inexpensively from a myriad of sources, then what about the other side of the transaction? What incentive is there for a business or political jurisdiction to issue debt when returns are so low? In addition, why would anyone purchase it? Right now, bonds are almost as costly as they could possibly be. For every corporate bond that's selling at a discount right now, a dozen more are selling at a premium.
Not surprisingly, those premium bonds are old ones issued when interest rates weren't as low as they are today. Never mind investment-grade bonds, even junk bonds are priced at close to their historical zenith.
However, bonds' classic selling point, regardless of any temporary market circumstance, is their stability. Zynga stock, for example, is a lot more likely to lose much or most of its value than is a Treasury note backed with the full faith and credit of the United States government. Most of the currently discounted bonds are of what's euphemistically called less-than-investment grade. Maturities are long, Fitch ratings are low. In the summer of 2012, your average corporate bond issuer can't offer you a decent regular payment without asking for a lot of your money up front. And why not? Money's inexpensive, as we established.
Inflation Vs. Deflation
There are two equally shrill factions on this issue, one of which might even know what it's talking about. Some economists and their devotees are convinced that with an activist Federal Reserve chairman and a president beholden to the idea of economic stimuli, we'll soon see inflation that will rival that of the Weimar Republic. The only difference will be that our wheelbarrows will be filled with electronic fund transfers instead of cash. If inflation is indeed coming, the borrowers will be the lucky ones. When payments come due, creditors will be entitled to nothing more than pennies on the (constant) dollar. Meanwhile, debtors will be able to repay their obligations even more easily than they do now.
The other side argues that central banks can keep interest rates low as long as necessary, and that if anything, we need to worry about deflation. Sure, the idea of today's dollar gaining value tomorrow sounds tempting to an economic agent who deals exclusively in cash. However, for those of us in the real world, the one where credit exists, too little inflation (or negative inflation) means too little liquidity. If deflation were to persist, only the most rock-solid bond issuers would be able to repay their debt. The Fed would print even more cash, and repeat as necessary.
SEE: Protect Your Portfolio Against Inflation And Deflation
Should You Buy Bonds Still?
Holding bonds has been traditionally regarded as a defensive strategy. Were the economy to collapse, and major corporations go out of business, bondholders would be in better shape than their stockholders would (though still in rough shape). Purchasing an issuer's debt, rather than its equity, gets you paid earlier should the issuer go bankrupt and have a fire sale. (Unless the issuer is General Motors and the federal government arbitrarily decides to rearrange the payment hierarchy, but that's a topic for a different post.)
But don't overreact and convert all your assets to gold and/or buy that fortified compound in the Montana woods just yet. It's important to remember that everything is cyclical. Our parents were stuck with 18% (that's not a typo) mortgages in the early 1970s and early 1980s, buying them gladly or grudgingly because they didn't have any other choice. Today's bond market, stagnant as it may be, is not a permanent or even necessarily a long-term state of affairs.
One more thing. In an ever-more-sophisticated financial market that loves to commoditize and aggregate, bonds still serve a purpose as the stuff that bond funds are made of. While any characteristic of a particular bond - its maturity, rating or callability - might be a red flag, diversifying via a bond fund eliminates or reduces that problem. Moreover, with certain types of bonds and bond funds, there's always the possibility of enjoying your gains tax-free.
SEE: Taxation Rules For Bond Investors
The Bottom Line
As an investment class, bonds might be overpriced in the short-term. However, there's no denying their utility as a hedge against, and alternative to, other more volatile securities. Bonds will continue to serve a purpose in the marketplace - whether for an issuer looking to raise funds quickly, or for an investor looking to diversify.