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With the stock market's horrific 2008 results under the microscope, it's easy to overlook the bond market's poor performance. Although Treasuries and other U.S.-government-backed bonds eked out small gains, junk bonds lost more than 20% through mid October; high-grade, long-term corporate IOUs surrendered 19%; and long-maturity, high-quality municipal bonds sank 17%.
Treasuries benefited -- and most other categories suffered -- from flight-to-quality buying. Looking for certitude in a period of deep uncertainty, panicked investors piled into government bonds, forcing up prices and pushing down yields. In mid October, the ten-year Treasury yielded 3.9%, while short-term Treasury bills paid less than 1.0%.
Meantime, consumer prices rose 5.4% over the past 12 months. The inflation rate may drop a bit as commodity prices recede, but "the way the world is printing money since the financial crisis started, I don't see how we can prevent higher inflation" over the long term, says Gregg Fisher, of Gerstein, Fisher & Associates, a New York City investment firm. Fisher says he wouldn't hold any Treasuries longer than four years. Neither should you.
Nor should you plow into junk bonds yet. Many junk-bond mutual funds are sporting double-digit yields. But if the economy enters a deep recession, defaults will rise and prices of junk bonds will fall further.
Instead, as the world's financial system heals, focus on high-grade corporate and muni bonds. Their yields are unusually high because of the fear and confusion in the financial markets. Values of sound bonds are bouncing wildly. A Wal-Mart bond carrying a 6.5% coupon and maturing in 2037 traded for $109 around Labor Day (that means one such bond cost about $1,090). In mid October, the same bond sold for less than $90 and yielded 7.5% to maturity, although Wal-Mart's business is excellent and its bonds are rated AA. Why? Apparently, some traders see a lot of risk in Wal-Mart. We don't.
In munis, it's the same story. Many are paying tax-free yields of more than 5%. An AA-rated Port Authority of New York and New Jersey issue traded for $83 in early October; a few weeks earlier, it changed hands for more than $100. Generous yielders of similar quality are on sale all over America.
NEXT: Are Banks Still Buys?
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