by Steve McDonald, Bond Strategist, The Oxford Club
Monday, November 5, 2012: Issue #1898
All the doomsday predictions about a sell-off in the bond market exclude one fact: Hold your bonds to maturity and you don’t lose any money.
A maturity date is one of the beauties of bonds. When a bond matures no matter what the market price is, or has been, you still get your principal back, and you collect your interest until then.
That’s not losing money; that’s making money!
The problem – and it is a real problem – isn’t bonds or even their current high market prices… it’s the people who own them. Black and white shock drives most bond holders to panic sell. Thus throwing the safety, cushion and returns bonds offer out the window.
It’s what I like to call “black and white shock.” And it happens when you get your first monthly or quarterly statement in the midst of a sell-off – whether in stocks or bonds. You look at the market value, which will drop, and you sell to limit your losses. The fact is, however, you don’t have any losses until you sell at a loss.
But no one is in the mood to listen to that kind of logic when they think their money is evaporating.
Telling investors to hold and not panic sell, and getting them to do it, are two very different things. The reality is, virtually everyone sells into a sell-off, that’s why it’s called a sell-off.
To make bonds really pay, you have to let bonds be bonds: Pay their interest and mature. And limit your panic selling.
The only way to do that is to have a reasonable time horizon in your portfolio, less than seven years. If your bond portfolio – or bond ETF or mutual fund – has a 12- to 20-year average maturity, and interest rates are going through the roof, you can’t blame anyone for selling. Market prices will drop and the paper losses will be big.
Looking at a portfolio that’s down in market value and underperforming for the next 12 to 20 years is too much for just about anyone. And this is the exact situation most investors will find themselves in when this bond market sells off.
The huge buying on the long end of the bond market for the past few years is going to leave almost everyone in “black and white shock.”
This whole situation is manageable and avoidable. You simply buy and hold short maturity bonds. I’ve been banging the table about this for years and finally people are beginning to listen.
You can’t eliminate all market fluctuation, and virtually all stocks and bonds will drop on value when inflation takes over and rates start going up. But, short maturities significantly limit market fluctuations and give you a psychological edge that will allow you to sit tight and let your bonds do what bonds do best.
This is the only viable bond play left in this market!
Facing six months to three years of underperformance is immensely easier than 20 years. Almost anyone can tough it out for a few years, yet no one has the backbone for two decades.
Most investors avoid the short-maturity scenario because the yields are usually very low, but there are exceptions.
‘Short Maturities in Out-of-Favor Industries’
Buying short maturity bonds in out-of-favor industries, looking for improving trends in beaten-up companies, and using all the bargain hunting skills we have (but seem to forget when it comes to investing) can get us annual returns well above what the stock market is averaging.
Let’s take a look at an example…
Is there any industry more beaten up than coal? The huge glut of natural gas in the United States has driven the conversion of many electric-generating plants to gas from coal. Currently, prices for coal have been in the toilet and life in general has been awful for the coal business. But that’s starting to change…
In September alone, coal use by electric generating plants has increased, the cost per ton of coal for Westmoreland has dropped from $25 to $17, their debt is expected to drop from $400 million to $240 million, and earnings per share is expected to go from a loss of $0.31 to a profit of $1.16.
Pardon the Pun, But Westmoreland is Smoking!
WLB has a bond (CUSIP: 960887AB3) with a 10.75% coupon that’s selling for right around par, or $1,000. It has a maturity of five years and three months.
No matter what happens to the bond market or inflation, you’ll receive $107.50 per year for each bond in a company with improving margins and lower costs that’s showing improvement in every direction.
Before you ask, yes, if rates start to move up you will see a drop in the market value, but it will be a fraction of what a 10- to 20-year maturity will drop. And you’ll get paid your 10.75% interest and $1,000 at maturity.
The Fed has stated in no uncertain terms that they will not raise rates, even if the economy shows improvement, until 2015. So, in all likelihood this so-called bond bubble isn’t doing anything until then, and rates should stay put.
That means rates are most likely to run up after 2015, and this five-year-and-three-month maturity bond will be a two- to three-year maturity. And a two- to three-year bond will see almost no market fluctuation, not compared to what will happen to the rest of the market.
That’s how you manage your time horizon in this market and create a situation where you can stay put when the fireworks start. That’s how you make money when everyone else is getting crushed.
An annual return of 10.75% and your entire principal back at maturity no matter what the market does; that’s making money not losing it!
Short maturities really are the only viable play left in this bond market. Push the maturity envelope trying to increase your return a little, chase a little more interest annually by getting into a long-maturity leveraged bond fund, and you’ll be part of what will be one of the greatest catastrophes in market history.
Stay disciplined, hold your bonds when everyone else is selling at huge losses, stick with maturities less than six to seven years, and you can come out of this bond bubble looking like a champ.