As the economy slowly recovers from the worst financial crisis in decades, it’s getting likelier by the day that the Federal Reserve will soon wind down its stimulus programs. In an effort to boost the economy, the Fed embarked on initiatives such as holding short-term rates at zero and purchasing billions in long-term bonds every month.
Now, fears that the Fed will soon draw down its stimulative asset purchases have sent the bond markets reeling. Longer-term rates are spiking, and as a result, bonds are plunging.
With economic data signaling a modest recovery, perhaps the Fed is overly optimistic. Do bonds represent a decent investment at current levels? Or is the sell-off just beginning?
A disastrous month for bonds
Bonds all across the risk spectrum are taking it on the chin in August. The market’s “taper tantrum” resulted in higher rates across the board and, by extension, lower bond prices.
The sell-off has not been limited to lower-quality bonds. Highly rated corporate bonds are also suffering. The iShares IBoxx $ Invest Grade Corp Bd Fd (NYSEARCA:LQD) lost 4% through the first three weeks of August.
The yield on the iShares IBoxx $ Invest Grade Corp Bd Fd (NYSEARCA:LQD) is now near 4% — its highest level since early 2011. Considering that the 10-Year Treasury Bond yields just 2.8%, investors are getting a fairly attractive opportunity.
From an underlying credit-quality perspective, though this fund looks strong. Almost 60% of the iShares IBoxx $ Invest Grade Corp Bd Fd (NYSEARCA:LQD)’s holdings are rated “A,” “AA,” or “AAA.” As a result, investors don’t have a great deal of credit risk to worry about.
Even high-yield bonds, which were already sporting generous yields before interest rates started surging, have lost value in recent weeks.
The SPDR Barclays Capital High Yield Bnd ETF (NYSEARCA:JNK) has dropped sharply in the past few months and now yields 6.5% — its highest yield since early 2012.
Investors should note that high-yield bonds have worse credit ratings than higher-rated issues. At the same time, 6.5% is nothing to sneeze at, and investors are at least being handsomely compensated for the heightened level of risk.
Meanwhile, preferred stocks haven’t been spared any carnage. “Preferreds,” which carry elements of both bonds and stocks, have taken a beating in August. Consider the John Hancock Preferred Income Fund (NYSE:HPI), which has lost more than 16% of its value in just three months.
Preferred stock is commonly known as a hybrid security that displays characteristics of both debt and equity securities.