Published: September 15, 2010

Everywhere I turn, I see headlines about the "bond bubble."

"The Great American Bond Bubble" -- August 18, 2010, The Wall Street Journal

"The Unstoppable Bond Bubble" -- August 16, 2010, Fortune

Clearly, the demand for bonds has been rising -- pushing prices up and pushing yields down. The Investment Company Institute reported that from January 2008 through June 2010, bond funds saw an inflow of $559 billion. Equity funds, in contrast, experienced withdrawals of $242 billion.

But are bonds overpriced? Do they represent more risk? Are they bubbling?

The chart below shows the yield spread between the 10-year Treasury note and corporate bonds rated "Baa." According to Moody's, "Baa"-rated bonds are investment-grade, but still carry moderate credit risk.

As you can see, the difference between corporate bond yields and Treasury note yields grew during the financial crisis. In December 2008, corporate bonds were yielding 8.4%. At the same time, investors clamored for the safety of U.S. Treasuries. The yield on the 10-year Treasury fell to 2.4% -- 600 basis points lower.

As the financial credit crisis improved, the yield spread narrowed. But it still sits above pre-crisis levels. The "Baa" corporate bond yield in August was 5.7%, just about where it was five years ago. The yield on the 10-year Treasury, however, is 150 percentage points lower than it was five years ago.

If I had to pick a group of bonds that may be a little pricey, it would be U.S. government debt. I understand why investors may be reluctant to buy equities. It takes a strong stomach and an acute eye to withstand the rocking and rolling of the U.S. equity market these days.

But I'm a little stymied at why investors would settle for the 2.7% yield on a 10-Year Treasury note -- or the 0.12% yield on the 3-month Treasury bill.

Corporations are Stronger
The U.S. economic recovery may be slowing, but companies have strong balance sheets. The non-financial companies in the S&P 500 are sitting on $837 billion in cash at last count -- which is much higher than normal -- and +26% more than they had last year.

The default rate on even the most speculative corporate bonds has dropped this year. In June, the ratings agency Fitch reported that the default rate on high-yield bonds was running at a full-year rate of roughly 1%. In 2009, the default rate for speculative bonds was 13.7%.

Many Non-U.S. Economies Are Stronger
While U.S. economic growth could slow, other economies in the world continue to show strength. Vietnam's economy grew +6.4% in the second quarter of 2010 and could grow by +7.0% this year. The International Monetary Fund expects India's economy to grow +9.4% in 2010. And Chile just reported its best quarter of economic growth in five years.

It's true, other countries are leaving the U.S. economy in the dust, and paying our significantly higher yields on their government debt.

Action to Take --> While U.S. debt is considered a classic safe haven, the price of safety may have become just a little too high. There is not much upside potential left for U.S. Treasuries. And there certainly is little yield compensation -- especially when compared to the 8.0% yield of the PIMCO Corporate Income Fund (NYSE: PCN) and other bond funds.

Bonds are in demand; there is no denying it. But there are some good reasons to like corporate and foreign debt.

Inflation is low -- increasing just +1.2% in the last 12 months. The U.S. equity market is being stingy with returns -- the S&P 500 is up just +2% year-to-date. Many corporations and emerging markets have healthy balance sheets, easily carrying their debt burdens. And baby boomers are growing older, ensuring a continued demand for fixed income securities for the foreseeable future.

-- Amy Calistri
Editor
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P.S. -- Bonds are a major part of my $200,000 real-money portfolio in The Daily Paycheck, so you know I'm not just talking the talk -- I'm putting money where my mouth is. If you want to learn more about The Daily Paycheck -- including the rules I use to generate a daily stream of income, I invite you to read my free course: 51 Dividend Checks a Month.