Investing In Bonds – What You Need To Know About Falling Prices

| December 13, 2010 | 0 Comments

It had to happen… It was inevitable.  After several years of high demand for US government bonds… the ultimate safe haven… investors are now wising up to the risks.  Despite every indication bond yields should remain low, just the opposite is happening.

Bond values are being destroyed and one industry group is poised to benefit.

Before I get to that, let me show you what’s happening right now in the markets.  Below is a chart of 10 Year US Treasury bond prices.  They’ve literally fallen off a cliff… and I don’t see them rebounding any time soon.

This activity makes no sense… until you dig a little deeper.

If you remember, just a few weeks ago Ben Bernanke and the Federal Reserve announced another round of quantitative easing.  Everyone is calling it QE2.  The markets had been hinting at it for months and stocks climbed on the “feel good” idea of easy money.

With the Fed out buying hundreds of billions worth of bonds over the next nine months (quantitative easing), prices should be rising… or at least remain stable.

However, when news of QE2 became official, some strange things started happening.  The US Dollar got stronger – not weaker.  The stock market continued to climb.  Inflation was nowhere to be seen.  And bond prices started FALLING!

Apparently investors took this latest round of government buying as an opportunity to sell their bonds.  That drove down prices and caused rates to move higher… the exact opposite of what the Fed wanted.

Why is this happening?

The recent increase in bond yields point to fear of inflation.  The Fed claims they know how to control inflation, but unfortunately, the QE2 and now the possibility of a QE3 is putting the fear of rising inflation front and center.

Bond yields are a good measure of inflation expectations over the next few years.  And what they’re showing now should give bond investors pause.

If you own bonds right now, give that idea a second thought.  Here’s the risk with bonds.  As yields rise, prices drop… any threat of inflation and the Fed will need to increase interest rates.  It’s not a question of IF… it’s a question of WHEN!

Anyone holding bonds right now is going to see their account get hammered.  The best time to sell was a few months ago… the second best time is right now.

As inflation shows up, anyone holding bonds is only going to see their asset values squeezed – and not in a good way.

So who benefits from falling bond prices?

I think the one group of companies set to benefit from this bloodbath in bonds is the REITs.

Here’s my thinking…

As bond prices continue falling, more and more investors will realize they need to get out.  But there’s a problem.  Bonds provide a steady stream of income to their owners.  To replace that income stream, they need to find yield elsewhere.  The most likely source is REITs.

REITs often provide steady and growing dividend yields.  And their payouts are tax efficient.

Best of all, with inflation rearing its ugly head, hard assets are the perfect place to invest.  One of the best hard assets to own is real estate.  Inflation will drive the value of real estate higher and that should push up the value of REITs owning real estate.

Buying a REIT is the perfect way to kill two birds with one stone.

One way I like to invest in the REIT market is through a diversified REIT ETF.  You could dig into all the details and holdings of any number of individual REITs, but it’s easier to spread your investment out over a number of them.

Take a look at iShares Dow Jones U.S. Real Estate Index Fund (IYR).  I own this ETF in my own account.  IYR has over $3.0 billion in assets and currently yields just over 3.5%.  The fund owns pieces of 77 different REITs and has a small fee of 0.47%.

In the last year, it’s up more than 28%.

If you own bonds, start paring back your ownership soon.  You don’t want to see your hard earned money get flushed down the toilet.  And if you’re looking for a good industry to invest in, look no further than REITs.  They will throw off a steady stream of tax efficient dividends… kind of like your bonds.  Plus, their base of hard assets will be invaluable once inflation really takes off.  It’s a win-win any way you look at it.

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Category: Bonds

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The Dynamic Wealth Report works with a number of staff writers and guest experts who specialize in everything from penny stocks to ETFs to options trading. These guest analysts post under the 'staff writer' moniker for ease of use.

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