How to Invest in Bonds Without Being Slaughtered

Steve McDonald
by Steve McDonald, Bond Strategist

[caption id="attachment_29406" align="alignright" width="220" caption="There’s a way to shift gears out of the stock market’s volatility and into the safety, reliability and predictability of bonds, but almost no one is doing it correctly."]How to Invest in Bonds Without Being Slaughtered[/caption]

The rush is on and the next cliff is coming into focus.

The herd has formed, and the uninformed and best guessers are filling the ranks for the next plunge into the money abyss.

I’m talking about the huge shift from equities to treasuries and bond funds. It’s grown to numbers even I didn’t expect when I started writing and talking about it last year, and I’m convinced it will be the next disaster.

Most of you know I’m the bond guy at The Oxford Club, so this at first may sound contradictory, but it isn’t. There’s a way to shift gears out of the stock market’s volatility and into the safety, reliability and predictability of bonds, but almost no one is doing it correctly.

Yes, just as in stocks, there’s a right way and a wrong way to invest in bonds. And, just as in the stock market, if you don’t know the “ins and outs” of bonds, you’ll lose a lot of money when the market goes against you.

Not might lose or could lose, will lose!

Most investors know less about bonds than they do about the stock market. And the current mad rush out of stocks into bonds – bond funds especially – will result in one of the biggest money disasters the average guy has ever seen. It will dwarf the losses in 2007 and 2008.

Barron’s reported recently that most investors are buying income investments that are paying less than the inflation rate. That’s how out of touch most people are about bonds, and this is only the beginning and a small percentage of the losses they’ll see.

All the Wrong Moves

There are two basic issues at play that guarantee disaster for those rushing to the wrong bonds and bond funds.

One, most people are rate pigs.

Two, these rate pigs aren’t using any of the safety tools that can make bonds safe and rewarding.

The “rate pig” idea is quite simple. When the average guy goes into bonds he looks for the best yield he can get. Forget about leverage, duration, maturity, the affect of rising rates and quality - to the pigs it’s all about that yield number.

It’s nothing short of financial suicide! I’ll show you why in a minute.

Safety tools like shorter maturities, staggering maturities, limiting position sizes, shopping for mispriced bonds and buying on market dips or bad news are being ignored. The list of things you can do to protect yourself goes on and on, but rate pigs look at none of these factors and simply buy yield.

This mad rush, ignoring safety and looking only at yield will be at the root of the coming debacle in interest sensitive investments.

Here’s how it will unfold...

Bonds are interest rate sensitive. When rates go up, bond market values drop. How much they drop is a function of maturity and quality. The longer the maturity of a bond the more it drops with a one-, two- or three-point interest rate increase.

The lower the quality of a bond, the more it tends to drop in value when rates go up, but maturity is the overriding factor in the formula.

For almost four years we’ve been sitting at some of the lowest interest rates in our history, it’s no longer a question of if rates will move up, but when.

As rates move up, the market value of bonds will drop, but the value of bond mutual funds will drop even more. Most bond funds are leveraged, which means they borrowed money against the portfolio to buy more bonds to pay a higher yields to attract rate pigs. The cost of that borrowing goes up with the rates, as well. It’s a vicious circle.

As the market values drop, and they will really drop in the longer maturities, investors who never understood the relationship of value to maturity will start panic selling. As they do they drive prices down even more.

Get the picture?

The really sad part of this scenario is that most investors won’t realize how much damage has been done until it’s too late. The vast majority will be left wondering what happened.

As I said, this doomsday outcome is avoidable and there are ways to invest in bonds using a number of loss limiting factors that can allow you to earn above market rates – double digit in many cases – without being crushed by the herd when rates move up.

Rules of the Road

  • Rule No. 1 to Survive the Coming Debacle: Buy Short Maturities

If you’re selective, and realistic in your expectations, you can stay on the ultra-short end of maturities, less than a five-year average, and still earn returns above what the stock market is paying. You may earn a little less than longer maturities offer, but the drop in value when rates increase is significantly less.

Take a look at the table below. It illustrates this point. These are approximate numbers buy very close to what will actually happen.

1% 2%   3%
30 Year 84.55 72.32 62.58
10 Year 91.82 84.41 77.68
2 year 98.05 96.15 94.29

This shows the drop in value of the two-, 10- and 30-year treasuries with one-, two- and three-point interest rate increases.

As you can see, the 30-year bond with just a 1% increase in rates will drop in value to 84.55%, or from about $1,000 to $845.50.

The two-year however will only drop to 98.50% or $980.50 with the same increase in rates.

As rates continue to move up two and three points, the 30-year will drop as low as 62.58, $625.80.

Keep in mind that these are numbers for treasuries – the most “secure” investment in the world. Their drop will be less than all other types of interest sensitive investments.

Maturity is the key. Stay short!

  • Rule No. 2: Limit Your Position Sizes

The tendency in bond investing is to plow a lot of money into a few bonds that look good at the time. I have seen some portfolios where people have had one third to one half of their money in one and two bonds of big-cap, big name companies.

Financial suicide, especially in this market!

Buy as few bonds as you can in any one position and buy many small positions. Spread your risk around as much as you can. It’s the same as diversifying in stocks.

Small positions also have another function. Two bonds of the same maturity may not drop the same amount. There are many variables that drive this value shift, too many to detail here. The idea though is to maximize your safety by using every tool, so keep them small.

  • Rule No. 3: Stagger Your Maturities

Ladders are a familiar tool to most people, but staggering gives you more options in a rising interest rate environment.

Below is an example of a typical ladder of bonds.

Company Maturity Expected Return
AGF 9/15/13 6.07%
GMAC 3/15/16 7.5%
Citi Group 11/15/21 8.47%
SLM Group 6/15/24 7.85%
Albertson’s 5/1/30 9.78%

The idea is to have a bond maturing every so often and then move the money out to the long end of the maturity curve. This gives you an expanding portfolio and also allows you to buy into a rising interest rate market.

The problem is that when rates start to move up you won’t have a few years to buy into it. They’ll move quickly and you have to be ready for the shift.

Below is what I called a staggered maturity portfolio. As you can see, it has bonds coming due every few months rather than every few years. It gives you more opportunities to buy into what will be a very rapidly rising interest rate market.

Company Maturity Yield
International lease 9/20/13 6.63%
Sabine Pass 11/30/13 6.216%
GMAC 12/31/13 6.18%
Alon Refining 11/1/14 12.69%
Alion Science 11/1/14 14.01%
Harland Clarke 5/15/15 16.02%
First Data 9/24/15 12.63%
GMAC 3/15/16 7.5%

Average maturity 3.3 years, average annual return 10.78%

Obviously if you’re going to buy this many positions to fill this type of stagger, you’ll have to buy smaller positions. You also don’t have to have quite as many positions as this example shows.

The idea is to have at least one bond a year coming due and in small positions – one to 10 bonds. The exception is if you’re working with a large amount of cash, you can increase you positions accordingly.

Short maturities, no leveraged mutual funds, stagger your maturities, limit your positions sizes and don’t be a rate pig.

Bonds can be a very stable, profitable part of your portfolio, but you have to follow the rules of the road or pay the price.

Good Investing,

Steve McDonald

P.S. In today’s Investment U Plus edition, I tell readers about a bond that fits all of my criteria. Not only is the maturity ultra-short, but it’s a beaten-down company in a beaten-down industry. It returns over 7% and matures in 2013 – just the type of opportunity I look for…

For more information on accessing today’s bond recommendation, click here.

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