A Slam Dunk in Bonds

Steve McDonald
by Steve McDonald, Bond Strategist, The Oxford Club
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If you know what to look for, the market will occasionally let you know what’s coming. And one of the best indicators of where a market is going is a capitulation.

A capitulation is a point at which selling reaches a high rate. Think about the fall of 2008 - everyone sold everything at whatever price they could get. I call it “the flushing effect.”

A capitulation normally involves selling, but in rare cases can be the result of buying. And it can happen in bonds. In October 2008, the selling in bonds got so crazy that AA- and AAA- rated banks saw their bonds drop 40% and 50%. The banks weren’t going anywhere and the bonds regained their value by the end of the year.

That’s a capitulation.

Recently there was a capitulation of another sort: a buying capitulation in bonds. And it was as good an indication of what is to come as any sell-related flushing effect.

Some purists may disagree with my use of “capitulation” for what happened in bond funds in January, but it was as irrational as any sell-off and marked the top of the market.

A record amount of money poured into bond funds in January. That in and of itself wasn’t news - money has been pouring into bonds for the last five years.

What is news is that the buying reached stupid levels and it was the first real signal that bond prices would begin to fall off and rates would increase. How can a buying event forecast rate increases?

Because it was all by the little guy - who is always wrong - and it was when the biggest dog on the bond block - the Fed - said it would use tapering to force rates up and bond prices down.

You see, a capitulation is not just about buying and selling. It is about buying and selling that is so stupid, so excessive, that it makes you shake your head in disbelief. This was stupid buying.

And, you never argue with the Fed! They are always right. That’s what made the fund buying so insane and qualified it as a capitulation of sorts.

Many analysts have been predicting it for some time, and the fund buying in January has convinced me that we are on the verge of a correction in bonds. I am finally on board.

The issue now is how to use this signal in the bond market to our advantage. It is really quite easy to do and will result in one of the biggest gains in our lifetimes.

The trick is to be invested in bonds earning well above the long-term stock market average and at the same time have cash available to buy into the market as rates move up, prices move down and returns go through the roof.

Remember, the cheaper the bond the higher the annual return. So, as bond buyers we want prices to drop as much as possible, just not the prices of our bonds.

The technique that will accomplish all three is called a staggered ladder. Simply put, a stagger will have at least one bond maturing every year for the next seven years and is made up of bonds with maturities of no more than seven years.

We limit the maturities to seven years because those will be the least affected by rising rates. A five-year average maturity will drop in price about one-fifth to one-tenth of longer maturities.

Despite the fact that at maturity a bond will return $1,000 no matter what the market price does, the less price fluctuation, the less the chance investors will panic when rates increase and prices drop. It is just a safety measure.

Here’s what a staggered ladder of short-term corporate bonds would look like. Note: The bonds listed are not buy recommendations. They are here only as examples of how to structure a stagger.

All of the bonds are priced at a discount, below par, 100 or $1,000, so the annual return is higher than the coupon.

We have about one year between the maturities of each bond. While the annual return of the portfolio is more than 16% a year, the key to success going forward and much higher returns is the maturities of the bonds - not the yields.

The fact that the stagger will have one bond per year maturing ensures that as rates rise, the portfolio will have money available to buy into what will be increasing yields and dropping prices.

This is how to collect returns two times the long-term return of the stock market and make what will be a bloodbath for the uninformed one of the biggest bonanzas of our lifetime.

As the correction takes shape we could see annual returns around 20%.

If you are positioned correctly in short maturities and you have the cash each year to buy into dropping prices, the sky is the limit on how much you can earn.

The alternative, the standard ladder, which has several years between maturities, will put the investor in a position where he will have to wait two, three, sometimes four years between maturities.

The market waits for no one. If you don’t have cash when the opportunities are presented, you will miss the boat.

Imagine if you had cash regularly available in 2008, 2009 and 2010 when the stock market was priced 30% to 60% less than today. That is exactly the opportunity a staggered ladder of short-maturity corporate bonds will give us.

And when you add to the equation the huge early warning we got from the fund buying in January, we have a slam dunk.

Only bonds allow you to structure a portfolio to plan to take advantage of better buys and higher returns. Take a look at bonds.

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