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Get out of any bond mutual fund or bond ETF that has an average maturity of greater than five years?

March 29th, 2012

We’re going to have a repeat performance of the ridiculously low prices we saw in 2009. But, this time it will be with much less risk and 100% predictable. In fact, this next buying opportunity is guaranteed! Imagine going back to February and March of 2009 and buying all the amazing bargains the market collapse gave us.

  • General Electric (NYSEArca:GE), currently almost $20 was under $9

  • Caterpillar (NYSEArca:CAT), now at $107, sold for as little as $21.17
  • The mighty Apple (Nasdaq:AAPL) was selling for $82.33

Everything in the market was at least 50% off, some even cheaper. The whole world was on sale, but it was on the edge of the abyss, too.

If you bought CAT at $21.17 and held it until today, its current dividend of $1.84 would be worth 8.69%. That’s a dividend!

Well, get your checkbooks ready because we are about to see a repeat performance, but this time in bonds.

All courtesy of the Fed!

Unlike the stock opportunities we saw in 2009, this bond buying opportunity will have all the security, stability and predictability we expect from bonds, but almost none of the unknowns that kept most of us out of the market 2008 and 2009.

The only reason most bonds will drop in value is because interest rates have to move up from their current 0%. It is one of the few guarantees you will ever get from the markets: When rates go up bond prices come down.

It’s a law of nature, at least the nature of the markets.

There won’t have to be bank failures, credit default swaps, FNMA or Freddie Mac, no AIG or Lehman’s and there will be no real change in the credit quality of the bonds.

The reason the prices of corporate, government and municipal bonds will drop will be because rates will move up. They cannot stay at 0% forever. This is how bonds and interest rates work.

If you have been following my articles about bond investing you know I have been recommending a super defensive corporate bond portfolio structure to minimize the effect increasing rates will have on  bonds I recommend.

  • Ultra short maturities, at discounts if possible
  • Very small positions, as few a one bond if necessary
  • A staggered portfolio structure where you have bonds maturing every few months instead of every few years

The reason for this severe strategy is to limit the price drop of the bonds we hold when rates move up.

If you use all three of these safety factors you will significantly limit the price volatility of your bond holdings and still earn returns of 10%, 15% and as much as 20% annually while we wait for the shift in the market.

But most importantly, the staggered maturity component will make fresh money available several times a year to buy into rising rates and dropping bond prices. This element is absolutely essential.

The last time we saw anything even similar to what lies ahead for the bond market was in the early 80’s under Ronald Reagan.

Anyone remember 18% mortgages? How about 15% money market rates, 12% savings, 8% and 10% on your checking accounts? Bonds, all types of bonds, were paying the same kind of crazy interest, but with huge capital gains, too!

The total return or what I call the MEAR, minimum expected annual return, interest plus capital gains, will be significantly higher than what we are getting now.

Expect to see prices discounted by 50% and 60% on all types of bonds, AA and AAA, too. That means at maturity you get all that back. If you pay $500 for a bond you still get $1000 for it at maturity.

Oh, and you won’t have to go out 10 years to get that kind of capital gain. One to three years will be plenty.

And, as prices drop current yields will go through the roof. A 6% bond purchased at 50, or $500, will pay a current yield of 12%.

12%! That’s what you will be earning just in interest on the $500 you invested in a 50% discounted bond with a 6% coupon.

Do the math; a 50% discount plus 12% every year in current yield, and this will be the norm.

This will be the biggest opportunity of our lives!

Here’s the Catch…

There is one problem, one little problem. There always is, isn’t there?

The entire money world has been consistently wrong about when rates will move up. For the past three years every top money manager, even Bill Gross, the king of the bond market, has been way off about when this guaranteed upward shift in rates will happen.

Gross got out of all his US government bond holdings in his portfolio last year. Wrong! Treasury rates dropped even more and he looked like a dope.

Four times in the past three years I thought rates had to move up. Wrong!

So, if you’re reading this and thinking you can wait it out, sit on the sidelines and time this move, forget about it! Better than you and I have fallen on their sword doing exactly that.

The best advice I can give now;

  • Avoid treasuries and muni’s. They are paying nothing but carry all the price volatility.
  • Get out of any bond mutual fund or bond ETF that has an average maturity of greater than five years.
  • Get out of any bond fund that has leveraging. It is a death trap!

That leaves corporates.

You can still buy certain corporates and earn enough to make it worthwhile, limit your maturities and stagger your maturities so you don’t have big gaps in time when you have nothing maturing, buy at a discount whenever possible and never pay a premium.

Do this and you will have used every technique available to limit your downside, earn returns way above the stock market and still have money available when rates finally move up.

It isn’t perfect but it is the best way I know of to invest with the significantly lower risk of bonds and still protect yourself against the inevitable.

Here’s an example of a bond that fits all my requirements.

To access the actual bond I’m referring to, click here.

The coupon, or the interest you are paid annually if you pay par or $1000, 100, for it, is 8.25%.

We can buy it for about 98, or $980 so our current yield is 8.41% (8.25 / 980). It matures in a little over two years on June 15, 2014.

It’s a callable bond, which means the company may buy it back on April 26 of this year at 101.375, or $1017.37. If it does the annual return would be around 46%.

If we hold it to maturity, we would receive the following:

Five interest payments of $41.25, that’s 8.25% a year, $82.50, plus a small capital gain of $20 per bond, for a holding period of 28.5 months.

Our minimum expected annual return for this bond would be 9.72%.

Here’s how the MEAR calculation looks;

5 x 41.25 + 20 / our cost 980 / holding time 28.5 months x 12 months =  9.72%

This is not a perfect solution to the interest rate situation we will have to face in the next few years. There will be bumps in this road. But, it is the only one I know of that will earn returns well above anything else out there, still get you the safety and stability of bonds and allow you to participate in the bargains that rising interest rates will give us.

Good Investing!

by Steve McDonald, Investment U Research


NYSE:BND, NYSE:TIP, NYSE:TLT


 

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