How to Avoid the Bond Fund Bloodshed
Eight years ago, the Fed forced interest rates below 1% for the very first time. The goal was to prevent the worst recession of our lifetimes from becoming another depression.
In that respect, near-zero rates did what they were supposed to do.
But the Fed’s efforts to keep rates near zero since then have hurt – not helped – the economic recovery.
According to recent data, when rates remain this low for an extended period, consumers see it as an indication of trouble rather than a stimulus. In this case, it has meant that consumers have actually spent less.
And that hasn’t been the only negative outcome…
Rates on savings instruments like CDs, money market accounts and U.S. Treasury bonds have been at record lows, too. As a result, saving rates are also down.
But those two things aren’t supposed to happen at the same time.
If consumers aren’t spending or saving, where’s the money? That’s one of the big unknowns haunting this recovery.
History Repeats Itself
Eight years of near-zero rates on savings accounts and CDs have resulted in one of the biggest threats to conservative income investing since the 1994 interest rate debacle.
If you weren’t following bonds in ‘94, let me explain what happened…
After a big recession, the Fed raised interest rates eight times in six months, and even ultrasafe widow and orphan bond funds were wiped out. No one was spared.
The losses were monstrous! Blood was flowing all over the street – most of it from bond funds that were never supposed to bleed!
Why did bond funds take such a bad beating? Because bond prices fall (and bond funds that hold them lose value) when the Fed raises rates.
This is one of the reasons The Oxford Club typically advises against bond funds.
If you own individual bonds, however, it’s a different story…
Interest rates don’t matter as much to you because you likely plan on holding the bonds to maturity. So even if their prices were to decline in value due to higher interest rates, you’d still be paid in full at maturity.
I’m writing about this today because bond funds are about to get massacred again. But this time, you can avoid the losses and still make money.
I’ll explain how in a moment.
But first, you have to understand a very important trend.
A Massive Mistake
Near-zero rates have forced conservative income investors to step outside their comfort zones in order to pay their bills. Most overreached and, irrespective of the risk, bought into any source that advertised high yields.
Virtually all the overreaching involved packaged products that use leverage and long-maturity bonds.
Now, leverage and long maturities will boost returns. But they’re also the driving force behind the next disaster in fixed income. It’ll be another 1994 or worse.
Leverage is nothing more than borrowing. Fund managers borrow against the bonds they hold to buy more bonds.
With more bonds paying interest, it increases a fund’s payout – as long as rates don’t go up. If they do, leverage has a huge downside.
As rates move up (and by now, we all know they have to) the cost of the leverage goes up, too.
That increasing interest cost is passed on to the shareholders in the form of lower share prices.
Increasing rates will also cause a drop in the value of the bonds held by the fund. And the longer the maturity, the greater the price drop.
Funds that are paying the highest returns have to hold the longest maturities. It’s a simple fact of bonds… Long maturities pay the highest rates.
Essentially, we’ll see increasing interest costs and sharply declining bond values, which means the funds’ net asset values (NAVs) will get crushed.
It’s a double whammy you don’t want to be a part of!
If you’re holding a bond fund with more than 10% or 20% leverage, funds that hold long-maturity bonds, or packaged income products that magically pay a lot more than the bond market averages (all this information should be available online), get out now.
A Safe Alternative
If you continue to hold any long-maturity or leveraged funds, you will be handed your head in short order.
This is a real threat. That’s why I’m not using the words “might,” “could” or “perhaps.”
This will happen when rates increase, and if you don’t do something now, you will lose a ton of money.
If you need income-producing investments to survive, and many of us do, you have to own individual short-maturity (less than 15 years) bonds.
This is the only strategy that will save income investors in a rising-rate environment.
First, short maturities don’t drop in value as much as longer ones do when rates climb. They’re less volatile.
And the less exposed you are to volatility in your portfolio, the less chance you’ll panic-sell when rates start to increase.
That’s where all the money will be lost… panic-selling due to market volatility.
Shorter maturities mean less time exposure. They mature sooner so you’re exposed to less market risk.
You also get your principal back sooner. This allows you to reinvest at (what should be) higher rates.
Since you’ll reinvest your principal at higher yields, after rates increase, shorter maturities also act as an inflation rider, too.
Owning individual bonds is much wiser and safer than owning bond funds right now. You avoid management fees, the cost of leverage and the negative effects they have on your return.
It’s a no-brainer… No leverage, no interest cost, no management fees and less market exposure!
And individual bonds will pay interest and return $1,000 at maturity no matter what market prices do while you hold them.
I know, it sounds too good and too simple, but this works. It’s the only way to ride out the rate storm that is coming.