Normally, people in the United States and from around the world think of highly rated corporate or government bonds as a safe place to put their savings relative to common stocks. Because the stock market had performed so poorly during the recession and because many foreigners turned to the United States as a safe place to invest, bond sales boomed.

If you were a holder of high-grade fixed rate bonds that you purchased a few years earlier when rates were much higher, you found yourself with big capital gains. That is, as rates went lower, the value of previously issued bonds increased. Many investment advisers in late 2010 were telling their clients to avoid bonds because inflation was going to come back.

a. Suppose you bought a $10,000 ten-year fixed rate bond issued by the U.S. Treasury in July 2007 that paid 5% interest. In July 2010, new seven-year fixed rate bonds were being sold by the Treasury that paid 2.43%. Explain clearly what was likely to have happened to the value of your bond which still has 7 years to run paying 5%?

b. Why would bond prices rise if people feared a recession was coming?

c. Why would fear of inflation lead to losses for bondholders?

d. Look back and see what happened in late 2010 into 2011?

Did the Fed keep rates low? Did the recession end? Did we see the start of inflation? Explain.