How to Invest in Bonds Like a Shark

Steve McDonald By Steve McDonald
Bond Strategist, The Oxford Club

Bond Investing

Imagine earning 8% to 12% on virtually every investment you’ve ever made.

That’s what a certain type of bond can offer you.

Even better, these same bonds pay when rates go down… They pay when rates go up… In fact, in the current market, even the high-yield version of these bonds is paying as promised 97% of the time.

High-yield corporate bonds, probably the least understood of all bonds – and the most maligned by the misinformed – have a 97% success rate in this market. And long term – looking back 80 years – a 94% success rate.

During the last several years – just like in stocks – the financial collapse that began in 2007 and continued on through 2009 was the biggest problem. But – just like in stocks – it’s normalized.

What all this means is that 94 to 97 out of 100 bonds, rated below BBB, pay their interest every six months and return $1,000 per bond in principal at maturity exactly as promised.

If you’re over 50, this is the kind of predictability you have to have in your investments. Numbers like these can mean real growth. The kind of growth we’ll all need to make it to and through retirement.

Now, here’s the really good part…

If you hold these bonds in the right type of portfolio, you can even turn the eventual sell-off in bonds into a massive payday that could support you through your old age.

So, why haven’t you heard of this strategy? If it’s as good as I say it is, shouldn’t everyone be in on it?

Well, it’s simple really…

The Stock Trap

Since about 1982, this country has been stock crazy. And, I’ll admit, it worked for a long time. That’s why bonds – especially corporate bonds – weren’t on anyone’s radar.

The payouts in stocks were almost automatic for decades. And you had to do practically nothing to earn insane returns: 12% to 15% per year just by handing your money over to a mutual fund.

But about 12 years ago, the losers started to dominate the equation.

That’s how a lot of us got into the situation of too little money to retire. The growth wasn’t there. Our 401(k)s and other retirement accounts got hammered. And now many investors are paying the price of stock-only portfolios.

Going forward, the only way most of us will make it is with consistent, predictable winners… Not the big hitters we grew so accustomed to during the last 30 years.

Now, it’s probably unrealistic to never expect to lose money in investing regardless of the strategy… There will always be a few unseen surprises lurking around to catch us off guard. But a 97% success rate is a pretty good place to start changing how you’ve been doing things.

The One Benefit Bonds Have Over Stocks

The amazing part of adding bonds to your investing strategy is that you know your expected return before you even invest one cent. It’s completely predictable, unlike stocks.

So, here’s a perfect example of the type of bond I look for. It has all the right numbers. It has a good annual return. And if you build a portfolio of this type of bond, you can enjoy a relatively risk-free, predictable and reliable investment life.

Again, that predictability and reliability I believe we have to have.

Stanadyne started as a screw manufacturer in the late 1800s. It’s now a worldwide leader in fuel systems. Their diesel fuel systems and fuel management systems power many of the diesel engines in use today.

The company offers a bond with a 10% coupon that matures on August 15, 2014. That’s a mere two-year hold. I’ll explain in a minute why that’s key…

We can buy the bond now below par for about 98.5, or $985, per bond. And it’ll return $1,000 at maturity (on August 15, 2014).

It also has a call on September 17, 2012 at par.

If the bond is called, that means the company buys it back from us before maturity. We’d book a short-term gain of 1.5%.

In contrast, if we simply hold this bond to maturity, the annual return will be about 10.15%.

This bond pays interest every six months – in February and August – to the tune of $50. That’s the coupon of 10%, or $100 per year, divided by two.

So, let’s break this down… For an investment of $985 you get about $200 in interest and a $15-per-bond capital gain at maturity (4 interest payments x $50, plus $1,000 – $985).

That’s not too shabby.

But the other reason to like this bond is its ultra-short maturity.

Staying Strong As the World Crumbles

Rates, as almost all of you know, are way down. That means prices for bonds are way up. But they can’t stay there forever. They will sell off at some point.

How much a bond sells off when rates move back up is primarily a function of the length of its maturity. The shorter the maturity, the less the drop in market value a bond will see.

A two-year bond like Stanadyne’s will see almost no fluctuation in price if rates move up.

But that doesn’t mean bond prices don’t move up and down. They do perform similar to stocks. But the volatility is much lower, even on high-yield corporates, and you know what you’re going to walk away with at maturity.

Personally, I don’t expect a real move in rates for about three years. But I always plan for the worst-case scenario. That way I’m hit with fewer surprises.

This is important… Despite the fact that this bond will pay exactly as described – no matter what interest rates do – most people will cut and run if they see a big drop in their monthly statement.

But selling when the market price is down is how you lose money, not make it.

My 20 years of working with average investors tells me they like stable market values, not wild swings. So, short maturities work best in this market and for the average guy.

The next part of this strategy is designed to deal with a bond market that almost everyone thinks is due for a sell-off.

When rates move up, the vast majority of bond and bond mutual fund owners will sell in a panic. This will create huge bargains if you’re prepared to buy when everyone else is selling.

The uninformed and skittish will be running for the hills – selling at a loss.

Sorry to sound so cold-blooded, but I can’t wait for these guys to bolt. In 2008, when everyone was fleeing in a panic, I made 90% and more in a matter of weeks by buying into the panic selling in the bond market.

But to capitalize on this stupidity you’ll need to have some cash coming out of your portfolio on a pretty regular basis to buy into the market fluctuations. So plan on having at least one bond maturing each year for the next five- to seven-year period. This ladder structure ensures cash is readily available to buy into what I expect to be a crazy sell-off in all types of bonds.

To get an idea of how much you can make when bonds finally do sell off, let’s consider our return if we could buy the Stanadyne bond today at 75, or $750, instead of 98.5, or $985.

If that happens, our total return would jump to about 60%!

Think about it: We’d walk away with $1,200 from a $750 investment.

Can you imagine a portfolio full of bargains like this? That’s what letting the other guy panic can do for your money.

So start being more of a shark. Be opportunistic. Don’t let emotions get in the way. Let the other guy make the mistakes. And let yourself make the money.