by Alexander Green, Chief Investment Strategist, The Oxford Club
Monday, June 10, 2013: Issue #2052
I received several letters from readers concerning my recent column opining that the 30-year bull market in bonds is over.
Some asked if it was really that big a deal that bonds fell by 2% in May. The answer is yes. It is a big deal, especially when 10-year Treasurys yielded just 1.7% a month ago. That slight sell-off erased more than a year’s worth of interest.
The paltry income from these bonds is why longtime credit analyst Jim Grant says Treasurys offer “return-free risk.”
Of course, some say the bonds could rally 2% from here and investors would be made whole again. It’s possible, but how likely is it? Successful investing is about analyzing probabilities not possibilities.
With the economy improving, commodity prices (including gold) down, the dollar up and the stock market strong, more investors believe measly yields that offer safety from the storm is not what they’re looking for.
Many of them are moving money out of their vulnerable bond funds and moving them into investments with more total return potential.
Get Out Now
Several readers also asked me to clarify what a leveraged bond fund is and why they should get the heck out of it if they have one.
A leveraged bond fund is the fixed-income equivalent of buying stocks on margin. We all know that a margined stock portfolio performs better on the upside… and hurts more on the downside.
The same is true of leveraged bond funds.
The fund manager borrows short-term to buy longer-term bonds with higher interest rates and is therefore able to earn “the spread” or difference between the two rates.
This is all well and good as long as the bond market is flat or climbing. But when it tanks – as it did in May – look out below.
If you don’t know whether your bond funds are leveraged or not, don’t just shrug your shoulders. Call the fund and ask. If it is… get out now. Don’t hesitate.
And if you own a closed-end fund that uses leverage, that goes double.
Twice as Deadly
Unlike open-end funds that are bought or redeemed at net asset value (NAV) at the close of each business day, a closed-end fund is publicly traded. That means it has both a market price and a net asset value. The fund may trade above its net asset value – in which case it is said to be trading “at a premium” – or it may trade below its NAV, in which case it is trading “at a discount.”
When times are good in the bond market, these funds tend to trade fairly close to their NAVs. But when bonds sell off, the funds often fall to a substantial discount.
As a shareholder, that means you will see your position decline more than the bond market (since the portfolio is leveraged), and you may also see the fund drop to a substantial discount to its NAV.
It’s a double whammy.
Believe me, there are folks who own closed-end bond funds who will be stunned when these funds drop 30%, 40%, 50% or more. Those sorts of drops are not uncommon.
But unless an investor – or his broker – has seen a real secular bear market in bonds, he may have no idea what he’s in for.
That’s why fixed-income investors should heed legendary fund manager Peter Lynch’s sage advice: “If you’re gonna panic… do it early.”
P.S. My colleague Marc Lichtenfeld has been tracking the bond market’s inevitable collapse for months now. In a new special report, he outlines what’s about to happen and how investors can fully protect themselves. He’s even narrowed in on a unique type of income investment that’s poised to soar as much as 160% when this “three-minute event” occurs.
To see his full presentation, click here.