London, England

Since the beginning of the year I’ve largely avoided common stocks and instead have favored high quality bonds and convertible bonds. Though bonds have lagged behind stocks since March 9, they’ve also produced the same returns or better in 2009 with far less risk and volatility.

Basically, I still don’t like earnings prospects and prefer to get paid to sit tight. Bonds provide that option.

Investment grade debt, as measured by the Barclays U.S. Corporate Bond Index, has gained 12.4% this year as yields on this benchmark touch pre-Lehman Brothers bankruptcy levels at just 5.47%; back in September those same bonds yielded 9.09%. And BBB-rated bonds – the lowest caliber of investment grade paper – have surged 20.5% this year.

Convertible bonds, however, have been absolutely terrific since hitting a multi-year low late last year following a collapse in the sector. By October 2008, convertibles were trading at their most attractive levels since 1994 following a massive exodus by hedge funds as convertible arbitrage strategies hemorrhaged. Convertible bonds have rallied more than 20% in 2009 – far ahead of the S&P 500 Index.

Another segment of credit I’ve also aggressively purchased since last December is TIPS or Treasury Inflation-Protected Securities – up about 6% this year even amid deflation in CPI or the consumer price index.

TIPS are the only bonds I’d be buying at this point. The entire gamut of fixed-income and hybrid bonds (convertibles, preferreds) have soared over the last five months and investors would be prudent to wait for a correction before committing new funds.

TIPS are still cheap with ten year break even rates showing a 1.94% annualized inflation rate from now until 2019; it’s highly unlikely U.S. CPI will trade below 2% over the next decade with a flood of money creation underway since last year and the deluge of Treasury supply required to fund deficits over the next several years.

The United States and other countries tied to the dollar will suffer the worst inflation debacle since the 1970s once we conquer deflation; monetary policies virtually everywhere are highly inflationary and the odds of the Fed successfully draining all of this massive excess liquidity to avert inflation is next to nil. Its track record since 1913 has been incredibly poor as an inflation fighting central bank.

It’s also instructive to mention that China has started purchasing TIPS after requesting more supply from Treasury recently.

Why anyone would want to buy nominal Treasury bonds – vulnerable to long-term inflation – is beyond me. But TIPS at least give you future inflation protection and the Chinese, whom are stuck with dollars, are beginning to redirect their recycled trade balances into TIPS.

I’m off to Oslo tonight. Have a good weekend.