Why I’m Praying for Bad News

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

Bond Investing

Below are two bond recommendations I made on March 24, 2009, right after the last huge sell-off in the markets.

I know if you follow bonds, these numbers seem like complete bunk for A- and AA- rated companies, but, I swear, these were actual recommendations.

  1. Buy the Wells Fargo 6.375% of 8/1/11 at 98 to 99, rated AA-, CUSIP 949746ce9.That was five interest payments of $31.87, plus a capital gain of $10, minus accrued interest of $9.91, for a total return of 16.1% and an annualized yield to maturity of 7.625%.
  1. Buy the Bank of America 6% of 2/15/12 at 89.5 to 90.5, rated A-, CUSIP 06050xdv2.That was six interest payments of $30, plus capital gains of $95, minus accrued interest of $7, for a total return of 29.61% and an annualized return of about 10.1%.

The most amazing part is that the 10.1% a year from the Bank of America bond and 7.625% from Wells Fargo were the minimum we earned. On average, in 2009, we actually earned about 40% on our closed bond positions.

That’s what a sell-off in bonds can do for you, and that’s why I have been praying for bad news. And, if recent selling is any indication, I may get my wish.

The Signs

Bonds are finally showing signs of weakness, and it’s the best news income investors have had in a long time.

Sales in bond ETFs and bond funds, driven by insanely high prices, have ramped up for the last few weeks.

How insane have prices gotten? The two bonds from 2009 in this market would pay only about 0.5% to about 1%. That’s nuts.

Treasury prices are so high you earn only a total of about $990 in interest if you hold the long bond for 30 years. That’s $990 on a $1,000 investment you have to hold for 30 years. That’s beyond stupid.

The only people buying Treasurys are the ones who have to.

Municipal bonds aren’t much better. The average yield from a decent long-maturity bond is about 1% to 1.5%. The only place you can get more is through bonds issued by Detroit or Puerto Rico… and you don’t want to own them.

Corporate bonds have been the only refuge for the past few years. But even in corporates, the average return on short-maturity bonds (less than seven years), has dropped from the low teens in 2012 and 2013 to the 6% to 8% range. The buying is furious and prices have shot up!

So obviously, as with all markets, the best time to buy bonds is after a good, healthy sell-off. You get higher income, plus stronger total and annual returns.

But that means trying to time the market, or what I call guessing the market. Hopefully by now you have learned that no one can do that successfully. You can get lucky once in a lifetime, but that’s about it.

If you haven’t learned that market timing is 99.9% impossible, then you probably have been sitting in cash since 2008 waiting for this bond market to plunge. And it’s been a long wait.

Even worse, by doing nothing, you have lost a huge amount of money to lost earnings, inflation and taxes.

But there is a way to structure a bond portfolio that will…

  • Keep your money working for you
  • Increase safety
  • Reduce price volatility
  • And make money available to you every year to buy into increasing interest rates or a sell-off in bonds.

It’s called a staggered ladder, and it’s so simple.

Breaking With Tradition

A traditional laddered bond portfolio has bonds maturing every few years. You would have a two- to three-year maturity bond, a five- to seven-year maturity, a nine- to 10-year maturity, all the way out to the long end of the maturity curve, as long as 25- to 30-year maturities.

You try to have as many as 10 different bonds with increasing maturity dates.

This has been a good strategy for many years. It makes cash available to buy into what has to be increasing rates in this market and you reap the benefit of higher yields from the longer maturity bonds.

But, because we have been in an artificially low interest rate environment, engineered by the Fed, when rates finally move, we will see an immediate and large snap back in the bond market.

The shift in rates and prices will be quicker than anything we have ever seen before, and that means we will not have two or three years to wait for cash to come out of our laddered bonds.

When this market corrects, and it may be starting right now, we will need to have cash available much sooner than a traditional ladder can deliver.

That’s where the staggered component comes into play.

Staggering your maturities means you have at least one bond a year maturing. Instead of waiting two to three years for cash from a traditional ladder, you have a minimum of one bond a year maturing.

Cash is available more often, and on a regular basis, to take advantage of any changes in bond rates and prices.

I told you this was simple.

In a more normal rate environment, a staggered portfolio could have some downside. Namely, rates could move up or down and you might be putting money back into the market at lower interest rates.

But, in our current situation with near zero rates, we have no chance rates can move much lower.

There is one issue with staggering that you may need to address.

Depending on how far out the maturity curve you plan to go (I recommend no more than seven years) you will have to own more bonds by different issuers to cover at least one maturity every year.

I recommend no more than seven-year maturity bonds, because it adds an additional level of price stability. Seven-year maturities and earlier fluctuate in price significantly less than longer maturities.

In the seven-year example, you would have to own a minimum of seven different bonds from seven different issuers.

A staggered bond portfolio of seven-year maturity or less gives you…

  • All the earning power the bond market can offer
  • Limited price volatility when rates move up
  • Cash available every year to capitalize on increasing interest rates.

It isn’t a perfect strategy, but it will keep your money working and set you up to buy into the next sell-off, which I hope isn’t too far away.