Lower Rates Equal Increased Risk Taking

Steve McDonald By Steve McDonald, Bond Strategist, The Oxford Club

Bond Investing

Maturity and “garbage” bond traps are slamming shut all over the bond market.

But most investors will never know they’ve stepped into one of these traps until it’s too late… And their money is gone.

Corporate bond purchases have reached levels never before seen – $143 billion last month alone – the most active September on record.

The Wall Street Journal recently reported that money has been pouring into investment-grade corporate bonds at a rate of $100 million per day. On top of that, there’s $250 million per day going into high-yield bonds, though most of that’s in mutual funds, which means small investors.

Investors looking for more yield than Treasuries can offer – and more stability than the stock market can provide – have been buying corporates like crazy. And it’s driving rates down to levels that even bond fund managers consider too low.

This amount of small investor buying is sending up two very big, and very red, flags.

Two Very Red Income Flags

The first is, from a historical basis, the most obvious and the most easily quantifiable. When the small guy buys into this kind of frenzy, we’re very near the top, or in this case, the bottom of yields.

Go back to the period immediately prior to any market correction – stock or bonds – and you’ll see this exact same type of buying. In my 30 years in the markets, this has always been one of the best indicators of a sell-off.

The second red flag is when the small investor starts to push the edge of the safety envelope in two ways.

  • First, to increase yield, they buy bonds with long maturities.
  • Second, they buy some of the real garbage that’s out there – another misguided yield-boosting technique.

Either one of these desperation moves will lose money. But the two combined are instant death when the coming sell-off finally gets started.

By now, the maturity issue should be very familiar to most of you. Generally speaking, the longer the maturity of a bond, the higher its yield. But, the longer the maturity, the greater the market price drops when a sell-off kicks in.

Maturity is the most common trap for the small investor.

Even those who understand the relationship of maturity to market price fluctuation rationalize it away by assuming that if bonds drop in value, they’ll simply hold the bond to maturity and collect the principal.

The problem is: They don’t.

When rates move up – which drives the market prices of bonds down – statement shock sparks panic selling. That’s seeing in black and white how much very long-maturity bonds can drop in value, and yes, Treasuries, too.

Panic is the only description for what will happen to long-maturity bond and bond mutual fund holders when this sell-off starts. You can expect market prices to drop as much as 50% to 60% on bonds with maturities over seven to 10 years.

If you can hold a bond to maturity through that – while you’re earning below market yields – you’re tougher than most. Because very few can.

Destroying Your Retirement With Costly Mistakes

A major problem is buying low-quality bonds, or “garbage,” for the higher yield.

This one kills me.

There are bonds out there paying huge returns: 20%, 30% and even 50% per year to maturity. Under normal circumstances, most people would never consider them. But this market is anything but normal.

Most retired investors have been living on one-fifth to one-eighth of what their traditional income investments have been paying… Investments like CDs, money markets and savings. Most are in desperation mode for income and are making some very costly errors.

They see it as doing what they have to in order to survive.

But it’s wrong on so many levels!

Here’s a bond that’s been getting a lot of attention from buyers. And most small investors would have trouble refusing it.

Rotech Healthcare (cusip: 778669AH4) has a bond with a 10.5% coupon that’s selling for about 60.9 – that’s $609 – for a bond that’ll return $105 per year in interest and $1,000 in principal at maturity on March 15, 2018.

The annual return at the current price is 23.6% per year. That’s a combination of the 10.5% coupon and the capital gains.

It has a call date of March 2015 that, if it’s called, will pay an annual average return of 38%.

That’s huge: 23.6% to maturity and 38% to the call!

Very few folks who rely on interest for their income wouldn’t take at least a second look at this one.

But here’s where reality takes its bite…

This company is losing money. In fact, it has a profit margin of -8.43%.

There’s no year-over-year growth in earnings or revenue. It has $514 million in debt and only $11.9 million in cash. And it only has a market cap of $14 million.

The earnings and revenue estimates are terrible. But it’s projected to grow by about 10% per year for the next five years. So, it isn’t completely bad!

Its only saving grace is that it’s a very short maturity of about 5.5 years. So, if it survives, it won’t get crushed in the sell-off.

If!

Income Rate Pigs for the Slaughter

From a rate hog perspective, the Rotech bond is hot! Of course, rate pigs are always the first to get slaughtered.

The saddest part of this scenario is, as a broker, it was much easier to sell a bond with a very high annual return with weak fundamentals than one with a reasonable rate and good numbers. In most circumstances, small investors want yield and won’t – or can’t – see anything beyond it.

There are bonds out there that’ll pay a very good annual return – in the 7% to 10% range – with some good coupons. But most income investors won’t give them a second look…

The same mania that drives folks to risky, speculative stocks also drives them to the big yields in bonds.

From the perspective of a guy with 30 years in the markets, it’s nothing short of nuts!

Now, here’s a bond that’s as boring and plain Jane vanilla as it gets. Nothing special about it except for the fact that it’s investment grade, it has great numbers and it’ll be there when it’s time to pay you your interest – twice per year – plus your principal at maturity.

Oh, and it has a 5.125% coupon. That’s about five times what you can get from a CD or money market.

Jefferies Group, Inc. (cusip: 472319AK8) has a 5.125% bond that’s selling for a slight premium, about 104 – or $1,040 per bond. It’s rated “BBB” and has a very short maturity of April 2018, an absolute essential in this market, less than six years.

Here’s a bond that’ll pay you when the company says it will. It’ll be there when it’s time to return your principal, with great fundamentals. But you’ll never hear anyone talking about it at a cocktail party or over lunch.

Virtually everyone in the money business knows that bonds are very pricey now.

Keep your head for a bit longer. Don’t get sucked in by long maturities or the garbage. Get rid of any long-maturity mutual funds. And you’ll have your pick of the bargains when the panic selling begins.