by Steve McDonald, Bond Strategist, The Oxford Club
Friday, March 1, 2013: Issue #1981
When the Italians couldn’t agree on one candidate, and the U.S. faced it’s so called sequester, it may have been the last shot of life support for the bond market, for a long time.
This is very likely the last hurrah for the 30-year bond bull market. It may also be the last chance for the multitudes that have been plowing money into bond funds to take profits and save their retirements.
This is no joke!
At this point, no one needs to be told that interest rates have to run up and bond prices have to fall. When this will happen, or what economic force will cause this unavoidable shift, is anyone’s guess. But, it will happen and for the unprepared it will be one of the biggest blood baths in market history.
The victims of this devastation will be the same ones who are suffering through the current ultra-low, artificially-supported low interest rates; the retired and other conservative investors.
These folks have been pouring money into any bond fund, and long maturity bonds, that offer anything resembling a livable return. The risk, and it is a very real risk to their ability to pay their bills, is they don’t understand how much they can lose when seemingly safe bond funds drop like rocks as rates increase.
The longer the maturity of a bond, or the average maturity of a bond fund, the higher the yield. But, longer maturities mean a much greater percentage drop in price when bonds begin to sell off.
Maturity though is only part of the problem.
The same bond funds, unfortunately the ones most were buying, that advertised the highest yields also have the highest amount of leverage. Leverage is the kiss of death in a bond selloff, and believe me, you don’t want this kiss.
Bond funds borrow money against the bonds in the fund’s portfolio to buy more bonds to generate more income. That’s how some bond funds seem to be able to pay a lot more yield than others. They leverage them to the max.
This is all fine and good until rates run up and the cost of that leverage takes off, too. It is a one-two punch that can cost you 25% and 30% of your principal in a heartbeat.
As the borrowing cost goes up, the value of the underlying bonds is going down. So, your share value is falling but it is being driven by two negatives, not just one.
Aggravating this whole mess is the fact that the highest paying bond funds, the ones that attracted all the money in the past five years, only hold very long maturities. Now you have three negatives driving the shares to the toilet; a long overdue selloff, very long maturities and leverage.
I’m not kidding when I say you don’t want to be on the receiving end of this monster. But that is exactly where most small investors are, on the receiving end of a vicious right hook they will never see coming.
Averting Disaster with a Three-Step Strategy
There is a safe alternative to this calamity, and considering how much bonds have run up in price, it’s very likely a win-win alternative. It’s a three-step strategy that will not only earn above market returns, 5% to 12% annually, but turn the eventual run up in interest rates into the biggest payday of your investment life.
Step one; sell any bond or bond fund with a maturity, or average maturity, greater than seven years. Also sell any fund with leverage. If you have held them for any period of time you should have a very nice capital gain.
A nice profit, that’s the first positive.
Next, buy ultra-short maturity corporate bonds, less than seven year maturities, in small positions, as few a one bond per position, over many industries. The idea is to limit your exposure to any one company and have bonds maturing every year.
Have at least one bond maturing each year for the next seven years. If you have the cash, try to have several bonds maturing every year.
This is step three of the strategy, I call it a Staggered Ladder. Having at least one bond maturing every year will give you fresh cash every year to buy into a rising rate market, at rock bottom prices, and we will have both..
That’s the second positive.
When rates run up it will not be an overnight shift. We could see short duration spikes, but the run up will average out over several years and it will give you the opportunity to buy great bonds every year at dirt cheap prices.
Dropping bond prices will crush those still in the long end of the market, but if you have money available each year to capitalize on it, it will be a bond buyer’s dream come true; higher rates, higher overall returns and cheap bonds.
The third positive.
In 2008, during the last panic in the bond market, I was buying AA and AAA corporate bonds as low as 50 cents on the dollar, with yields in the high teens and low twenties. 20% annual returns were common, several earned over 40%.
The key to this strategy is to not try to stay in the current market to the end. I promise you, you will be wrong. If you shop around, even in this market, you can find good high-yield bonds paying a minimum annual return of 5% to 12%.
The real kicker, high-yield bonds right now only have about a 3% default rate. That means 97% are paying exactly as promised. You can’t argue with those odds.
This advice may seem totally foreign and the opposite of what your gut is telling you. One reason for this is that bonds are the great unknown. Most small investors know more about options than bonds, and most of what they do know about bonds is 180 degrees out.
My 30 years in the markets, and having watched 30% of many of my client’s money disappear in 1994, the last time we saw really big rate increases, tells me it is the only way for conservative investors to avoid the beating that is coming and to capitalize on it.
Act now! The bond bull is out of steam. Don’t be under it when it falls.
The Bond Bull’s Last Run,