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TAG | Yield curve
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Investing in Bonds: Three Steps to Smarter Bond Investing
0 Comments | Posted by Alexander Green in Alexander Green
Investing in Bonds: Three Steps to Smarter Bond Investing
by Alexander Green, Investment U Chief Investment Strategist
Monday, March 5, 2012: Issue #1722
At our Oxford Club Chairman’s Circle conference at The Ritz-Carlton in Naples last week, I noted a decided optimism about the outlook for the bond market. This enthusiasm is almost certainly misplaced.
We’re at the tail end of the biggest 30-year rally in bonds the nation has ever seen. Recall that three decades ago, Fed Chairman Paul Volcker pushed the prime rate all the way up to 21.5% to squelch inflation. Long-term Treasury yields reached 16%. But from that pinnacle, long-term yields have plummeted to around 3% today. Bond prices have soared accordingly.
It isn’t just unlikely that today’s bond buyers will see annual double-digit returns going forward, it’s mathematically impossible. And yet I sense that many fixed-income investors don’t understand this.
It’s not unusual to meet an investor who has plunked money in a bond fund because “its long-term track record is excellent.” They don’t seem to realize that it’s also irrelevant. Never has the old saw, “Past returns are no guarantee of future results,” been more apropos.
This doesn’t mean you should avoid bonds altogether, of course. But if you’re going to buy bonds, now more than ever you need to be smart about it. Here’s what you should do:
- Ladder your maturities. You should buy two-year, five-year and 10-year bonds. If rates go up – as they will eventually – your bond prices will fall, temporarily. But you will get your principal back at maturity and be able to reinvest your principal at higher rates. And paltry as bond yields are today, they still beat the heck out of the 0.05% that the average money market fund is paying.
- Keep a close eye on expenses. In the world of fixed-income investing, keeping a Scrooge-like eye on expenses is essential. Why? Because it’s difficult to work magic in the button-down world of fixed-income investing. Managers rarely earn their fees. And 12b-1 fees can eat away at your returns like termites in an antebellum house. My advice is to stick with individual bonds, Vanguard funds (whose expenses are one-sixth of the industry average) and low-cost ETFs.
- Avoid leveraged bond funds. Ever wonder how bond yields can be so low and yet the yield on your closed- or open-end bond fund is higher, even after expenses? Open your eyes. Unless you’re holding junk bonds, your fund manager is using leverage, the fixed-income equivalent of buying stocks on margin. By borrowing cheap, he or she is leveraging the portfolio to add yield. This works just fine while bond prices are flat or rising. But when bond prices fall – as they will when interest rates rise – these shareholders will take a shellacking. Consider yourself forewarned.
Some fixed-income investors tell me they feel safe for now since Bernanke has pledged to keep interest rates low through 2014. Think again. The Fed has only announced its intention to keep rates low. (Future economic conditions could quickly change that.) The Fed is also keeping long-term bond yields artificially low by buying these instruments to goose the economy.
Inflation could tick up. The Fed could raise rates and/or quit buying long-term Treasuries. In the end, the Federal Reserve sets short-term interest rates, but not bond yields and prices.
Know this. Understand it. And act accordingly. Bond investors today should be in a defensive posture, capturing higher yields than what’s available in cash instruments, but prepared for that point in the future when bond yields will rise and prices will fall.
Good Investing,
Alexander Green
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U.S. Treasury Bonds: Why the Safest Investment is Now One of the Riskiest
0 Comments | Posted by Alexander Green in Alexander Green
U.S. Treasury Bonds: Why the Safest Investment is Now One of the Riskiest
by Alexander Green, Chief Investment Strategist
Tuesday, June 1, 2010: Issue #1271
U.S. Treasury bonds are the safest investment in the world.
However, that doesn’t mean they can’t be dangerous. Far from it.
Yet a few days ago, The Wall Street Journal reported that, “Long-dated Treasury securities are now the most favored financial assets for global investors fleeing the eurozone’s debt crisis.”
Talk about jumping out of the frying pan and into the fire…
Don’t get me wrong. I’m not one of those end-of-the-worlders who expect the U.S. government to default on its sovereign obligations. That won’t happen.
It wouldn’t even be necessary. After all, history shows that governments always prefer to inflate their way out of a debt crisis by cranking up the printing presses instead. That way they can achieve a de facto debt reduction simply by devaluing the currency.
If you’ve seen the photographs of German citizens hauling wheelbarrows full of cash into the bank during the days of the Weimar Republic, you know what I’m talking about.
Of course, I don’t expect inflation like that. And neither should you.
But what kind of inflation does an investor expect who loans his money to the government for 30 years at a rate of just 4.1%?
Why U.S. Treasury Bonds Could Bulldoze Your Portfolio
That 4.1% figure is the current yield on the long end – and it’s a bet that has a little upside potential and a whole world of downside risk. Why?
Imagine a seesaw with interest rates and inflation on one end and bond prices on the other. If inflation goes down, bond prices go up. And vice-versa.
But how far down can rates go on the long end? Unless we have the sort of deflationary environment that Japan suffered in the 1990s, the appreciation potential here is minimal.
On the other hand, if inflation rears its ugly head, long bonds will get clobbered. And the worse inflation gets, the worse these bonds will do.
I realize that inflation is not an immediate threat. Technology and deregulation have brought costs down over the past decade. And even oil prices have moderated lately.
But if the bond market gets even a whiff of higher inflation, these bonds will drop like a stone. And I’m betting that investors who weren’t around during the early 1980s – and even many who were – don’t realize it.
They are so busy patting themselves on the back for eliminating default risk – and picking up a 4% yield versus next-to-nothing on the short end – that they are forgetting about interest rate risk: the risk that higher inflation will send long yields soaring and bond prices crashing.
Don’t Let the Government Trick You into Speculating
Seth Klarman, President of the Baupost Group, an investment firm in Boston that manages $22 billion, says the U.S. government is inadvertently provoking its citizens into taking very bad risks right now.
How?
“By holding short-term interest rates near zero, the government is basically tricking the population into going long on just about every security except cash, at the price of almost certainly not getting an adequate return for the risks they are running. People can’t stand earning 0% on their money, so the government is forcing everyone in the investing public to speculate.”
Of course, most people aren’t exactly in a speculating mood right now.
So what are they doing? They’re buying super safe long-term Treasuries and earning over 4%.
Except that’s not a safe investment – as many will eventually learn to their chagrin.
Good investing,
Alexander Green
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