Are Low Bond Yields Here to Stay?
Ron DeLegge, Editor
September 30, 2009

SAN DIEGO (ETFguide.com) – For most of the year, conservative bond investors have been tortured with anemic yields.

Government treasuries with 1 to 3 year maturities (NYSEArca: SHY) are yielding around 1.50%. If you think that’s low, government bonds with even shorter maturities of 3 to 12 months are yielding between 0.12% to 0.38%. All of this has caused varying reactions.

As a result, some investors are snapping up higher risk bonds with longer-term maturities and questionable creditworthiness. Others are waiting for clues from the Federal Reserve, which controls U.S. interest rates and monetary policy. Are low bond yields here to stay?

Don’t Fight the Fed
Based on the Federal Reserve’s recent behavior, it seems content with leaving short-term interest rates near zero percent. Comments from Richard Fisher President of the Federal Reserve Bank of Dallas indicated the Fed won’t stop its easy money policy until they’re convinced that economic growth in the U.S. has definitely returned.

The total U.S. bond market (NYSEArca: AGG) as measured by the Barclays Aggregate U.S. Bond Index currently yields around 3.50%, down from a 52-week high of 5.67%. 

For now, the Fed is focused on stabilizing the economy and the wounded housing market. The Fed reaffirmed its intent to purchase $1.45 trillion of mortgage backed securities through the spring of 2010. The plan is to stabilize the housing market and restore it back to health.

Analyzing Credit Risk
One of the root causes behind the financial crisis was billions of dollars in mis-rated securities. Credit rating agencies assigned top safety ratings to securities that turned out to be worthless. Just a few days before its bankruptcy, Lehman Brothers was assigned a top credit score by hapless raters.

Oddly, lawmakers and financial regulators have blessed a monopoly on the credit rating business by allowing just three organizations (Fitch ratings, Moody’s and Standard & Poor’s) to rule the roost. Congressional investigators are looking into the matter, which is code for long live the status quo.

According to Wall Street Journal reports, ex-credit analyst Eric Kolchinsky, alleges that Moody's Investors Service and other rating agencies continue to mis-rate bonds and other debt securities.

Despite the recent uproar about the failings of credit rating agencies, not much has really changed. The business is still dominated by just three companies, making it difficult for the outside world to have an alternative perspective on the credit risk of corporate and government securities.

Remember History
Too many investors have already forgotten what happened in 2008. The implicit trust in credit rating agencies and the safety they assigned to corporate debt were rocked. Have these risks diminished?

An article titled, “Too Expensive and Ready to Collapse – U.S. Stocks, Bonds and China,” pointed out these discrepancies. Within just a few days back in October 2008, the iShares iBoxx $ Investment Grade Corporate Bond Fund (NYSEArca: LQD) fell nearly 20% and the iShares iBoxx $ High Yield Corporate Bond Fund (NYSEArca: HYG) dropped 25%.

Know Your Risk Tolerance
“I’m more concerned about the return of my principal than the return on my principal,” stated humorist Will Rogers. Of what value is a juicy bond yield if your bond issuer defaults and can’t repay you? This is a vicious lesson, many bond investors still haven’t learned. High risk junk bonds (NYSEArca: JNK) have been bid up over 31% so far this year by eager buyers desperately seeking seductive yields. How much longer can the feast last?

One way to ensure the return of your money is not to lend it to untrustworthy borrowers. Another strategy is to diversify your single issuer credit risk by not investing in individual bonds. Bond ETFs can help you to accomplish this goal.

One last tip is to avoid the temptation of following the crowd by chasing bond yields. Many investors have shipwrecked themselves by exclusively concentrating on yield and throwing credit and duration risk aside. Don’t make the same mistake.