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Charles Sandmel, CFP®, AIF® | Portfolio Manager

Many were reporting the bond market’s demise three months ago, including this author; but investor psychology often trumps economic fundamentals. When investors are fearful, they push up the price of investments that they view as safe—for example, U.S. Treasuries and gold. Consequently, returns for investment grade bonds during the second quarter of 2010 were very good indeed.

Perhaps the most frequently asked questions from fixed income investors are these:

1. Where can I get a decent return without unacceptable risk?
2. What will inflation do to the real value of my return?
3. What happens when interest rates rise?
4. Are states and local governments going broke?

Let’s take these in order.
To Question #1: In evaluating “decent return” and “how much risk is acceptable,” consider this:

• If the yield on your money market fund is 0.05%, and a one-year Treasury bill is paying 0.32%, the T-bill is producing six times the interest on the money fund.
• Currently a five-year bond will yield four to five times more than a one-year bond, both in municipals and Treasuries.
• Price risk declines as the time-to-maturity declines.

For these reasons, we assert that intermediate bonds offer a decent return for the risk.

To Question #2: In our view, inflation is not a serious near-term risk. Inflation is dormant due to slack demand. Unless…

• the business cycle roars back to the point where capacity becomes constrained, or
• until full employment pushes up wages, or
• unless the Federal Reserve deliberately overstimulates the economy

…we are not concerned about inflation. That said, there is always the risk of a commodity shock, particularly in energy sources, so inflation cannot be ruled out completely (or anticipated). And, if an inflationary surprise were to occur, longer term maturities would be more adversely affected than short-intermediate maturities.

To Question #3: Interest rates and the value of bonds move inversely. When new bonds are paying 2%, a 4% fixed-rate bond will sell at a premium to face value, and vice versa. Interest rates would rise under general expectations of inflation and/or the result of the Fed raising rates, which is probably a year or more away. The shorter the time to maturity, the less price risk there is in owning a bond. If you buy a five-year bond today, a year from now it becomes a four-year bond, and so on until the bond matures. Price risk is serious with 30-year bonds, but not so much with short and intermediate term bonds.

To Question #4: States and local governments are under fiscal pressure, to be sure. Revenues are down, and there are legal constraints that limit their options. For these reasons, we feel one must be very selective. We continue to like short/intermediate high-grade municipal bonds that finance real infrastructure for established communities.

Our clients hold bonds to generate income, stabilize the value of a diversified portfolio, and to preserve capital. While it is difficult to generate very much income with today’s low interest rates, investors are well served by preserving capital. As the conservative part of an overall portfolio, bonds remain attractive today.

Charles Sandmel is a First Affirmative Investment Advisory Representative. A 30-year veteran portfolio manager and past Director of the National Federation of Municipal Analysts, Mr. Sandmel manages fixed-income separate accounts for First Affirmative clients.