The markets continue to be volatile.

With the European countries still struggling to figure their way out of the debt mess, and even the well regarded bank like JP Morgan taking large losses on their hedging activities, it is understandable that some investors may decide move their assets to the relative safety of the bonds.

However, this safety is illusory.

The Inverse Relationship Between Bonds and Interest Rates

This is one of the fundamental principle of bond investing. It is well understood but still bears repeating.

The value of a bond goes up when the interest rates are low and it goes down when the interest rates are high.



We are currently in a low interest rate environment and there is not much lower the interest rates can go.

In fact, there is every likelihood that the interest rates will be raised as the economy gets on a sounder footing. Given this, if you buy bonds now (either directly or through a bond fund), you are not only paying a high price for the bond, but you are also locking in a smaller yield.

As interest rates go up, your bonds will lose value while your yield will not change (in a bond fund, your yield will rise slowly as the fund sells older bonds and buys new ones, but then you will realize capital losses along the way).

Return of the Junk Bonds

The hunt for the yield has grown so feverish that the junk bonds are now seeing renewed interest.

This is typically a sign that many companies have trouble accessing credit through normal channels (banking) and have to submit to high coupon junk issuance.

As a result, many bond funds have junk debt mixed in their portfolio to juice up their yield to attract retail investors. Junk bonds carry much higher default risk and are seldom a sensible investment.

If you are a bond fund investor, you should pay special attention to the investment grades that your fund is invested in.

As and when the economy becomes more conducive to accessing capital markets, there is also a risk that a great number of companies will flood the markets with their bonds as they finally start to expand and undertake capital expenditures.

Greater supply of bonds mean pricing pressure on the value of the bonds.

Equity Markets Offer Alternatives to Bonds

The European quagmire has dampened the equity market in the US and as a result the market has not kept pace with the improvement in the business fundamentals.

This can be seen much more clearly with the small and mid cap companies where it is not hard to find dividend yields of 3% or higher. These high yielding dividend stocks offer a great alternative to investing in bonds with the possibility of price appreciation as well, particularly if the stock is still fairly undervalued on most valuation metrics and the underlying business is sound and profitable.

If you worry about inflation returning to the economy (and I believe that interest rates and inflation will go up together), stocks are even more attractive.

Stocks generally do better as an asset class than bonds in an inflationary environment as the value of the business assets rise.

Your Asset Allocation Should also Adapt to the Economic Environment

If you follow the financial planning advice that is most often offered, you have probably set up your bond exposure to increase as you get closer to the retirement.

While this is typically a good advice, it does not take into account the fact that the economic conditions may be different for you, compared to say, someone who retired 10 years ago.

You should always temper your asset allocation strategy with the economic realities. Blindly selling stocks when they are low and buying bonds when they are high is not prudent.

About the Author: Shailesh Kumar is the founder of Value Stock Guide where he offers stock recommendations using value investing principles.