Bonds Won't Stay Bulletproof Forever

With more than a decade of turmoil for stocks, Treasury bonds have stood out as a seemingly bulletproof investment, producing huge gains for those who stayed the course. But as threats seem to mount against bonds, can Treasuries really keep giving you the protection you've come to expect from them?

Will two be the charm?
Over the summer, investors worried over the potential impact of an unprecedented cut in the U.S. Treasury's credit rating. As Washington's wrangling over raising the debt ceiling pushed the nation to the brink of a possible default on government debt, Standard & Poor's finally decided that the combination of soaring deficit spending and political paralysis at the federal level warranted taking away its top AAA rating. Yet in the aftermath of that move, Treasury prices didn't fall, as many had expected. Instead, they rose, and they now carry some of the lowest yields in their decades-long history.

Now, the question is whether crying wolf a second time will have the same impact. Earlier this week, Fitch Ratings maintained its AAA rating on U.S. Treasuries but reduced its long-term outlook for Treasury debt from stable to negative. The move, which can often act as a precursor to an outright downgrade, draws a line in the sand, as Fitch suggested that by 2020, overall debt levels as well as the interest costs of maintaining that debt would rise enough to justify dropping the top rating -- without significant action.

Yet again, Treasury prices barely budged. Even with a big jump in stocks, the iShares Barclays 20+ Year Treasury ETF (ASE: TLT) lost only a few pennies on the day, and based on its most recent monthly distribution, the long-term bond ETF now yields less than 3%. Shorter-term bond investments like the iShares Barclays 7-10 Year Treasury ETF (ASE: IEF) weigh in at an even more meager 2.4%.

Don't bank on bonds
Bonds have unquestionably been a lifesaver for investors' portfolios over the past decade. But it's not likely to continue, if only because of a simple mathematical fact: With rates already so low, there's very little room for bond prices to rise further.

In early 2000, long-term bond rates were above 6.6%. As they gradually fell toward their current level below 3%, the value of those bonds and their above-market interest payments rose. That contributed the extra returns from price appreciation on top of those attractive yields, producing a very attractive total return.

But now, both of those tailwinds are gone. At less than 3%, a 30-year Treasury doesn't provide much income. And barring a situation in which investors are willing to pay the Treasury to own bonds, it's mathematically impossible for yields to match the drop of more than 3.5 percentage points between 2000 and now.

Conversely, if yields start rising back toward historical norms, then bond investors could easily see conditions that rarely occur: price declines could more than offset interest income, producing negative total returns for bondholders.

Defend yourself
The obvious bond alternative that income-hungry investors are flocking to are blue-chip stocks with dividends that beat those 3% returns. Even within the Dow, you can find several 3%+ yielders, including Intel (NAS: INTC) , Johnson & Johnson (NYS: JNJ) , and General Electric (NYS: GE) -- and those stocks actually have some growth prospects to go with their income. Expand your view a bit more and you can find plenty more high-yielding stocks.

But even the safest blue-chips have risk that bond investors can't afford. To defend the fixed-income side of your portfolio, look to shorter-duration bonds or even bank savings accounts. Their rates will be lower, but they have far less exposure to potential losses. And with online savings banks from companies including Sallie Mae (NYS: SLM) and Discover Financial (NYS: DFS) offering 1% right now on federally insured deposits, safety still gets you a decent chunk of the income that longer-term bonds would provide -- along with the potential for increases in the future.

Treasuries aren't bulletproof -- and even though I was early with my initial call, I'm finally making my CAPScall for the iShares Barclays 20+ Year Treasury ETF to underperform the S&P 500 going forward. If I'm right, then bond investors who don't rebalance some of their exposure to less risky assets could be sorry.

Dealing with low rates is just one of the challenges of saving for retirement. The Fool's newest free special report, The Shocking Can't-Miss Truth About Your Retirement, has even more must-know information for every retirement saver.

At the time thisarticle was published Fool contributor Dan Caplinger tries to dodge bullets like Neo in the Matrix. He doesn't own shares of the stocks mentioned in this article. The Motley Fool owns shares of Johnson & Johnson and Intel, as well as having bought calls on Intel. Motley Fool newsletter services have recommended buying shares of Intel and Johnson & Johnson, along with creating a diagonal call position in Johnson & Johnson and a bull call spread position in Intel. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool's disclosure policy is like a bulletproof vest surrounding your entire body.

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