How to Survive the Coming Bond Bubble Collapse

There’s a huge opportunity coming in bonds. It won’t look like an opportunity to most; the press will actually call it a bust. But, with the right planning in place, it’ll produce huge returns with virtually no risk. In fact, as this “bust” develops, you’ll actually be able to increase your returns.

The tricky part will be fighting the urge to sell when everyone – and I mean everyone – will be cutting and running.

For the informed investor, this will be the biggest bonanza of the new millennium, and all you have to do is not sell.

Here’s how it will develop…

The Interest Rate Explosion

While the whole market is fixated on the Eurozone, the slowdown in China, India’s issues and “Obamacare,” interest rates are slowly simmering and looking for an excuse to explode.

The good news is that this explosion (and it will be a big bang when it hits) is very predictable. So you can prepare for it and actually set up yourself for a rich retirement while the rest of the market goes down the drain.

These increasing interest rates will affect every investment – stocks and bonds. It’ll be devastating for the unprepared.

For a big dose of reality about how bad this can get, take a look at rates in the early 80s and what they did to the stock and bond markets.

The DOW was in the 600s. Bonds were paying double-digit rates and selling for next to nothing.

But, if you’re in the right place, this unavoidable sell-off will be a huge payday!

How It Will Begin…

Interest rates can, and will, go back up when any of the following conditions fall into place. Obviously, this isn’t a complete list, but it includes the most obvious factors:

  • The world business community loses faith in our ability to pay our bills. That will cause the cost of our government borrowing to sky rocket and, with it, interest rates.
  • Our economy finally gets going again and the normal growth/interest patterns re-emerge. Under normal conditions, when growth gets into high gear, the Fed raises rates to control inflation.
  • Our money printing finally results in inflation. Rates have to go up to try to control inflation. This is the one we don’t want to see. But that’s for another article…

There’s no magic here. Any, or all of these three forces, can and will fall into place, and it will look like 2008, 2000 and 1987 all over again.

One of the Few Safety Valves…

In the stock market, one of the few safety valves that’ll protect your assets will be tight trailing stops. Properly used, they get you out as stocks start to drop – and they will drop.

Lock in your gains and limit your losses… that’s the best strategy for stocks as the market absorbs the higher rates.

Bonds will drop, too – a lot. Virtually no investment will be spared.

But, if you hold the right type of bonds, the way to make money will be to not sell. It’s counter intuitive, I know, but this may be the only way to actually make money in the coming rising interest rate environment.

What to Do About Bonds

As rates go up, the existing bonds on the market will drop in value.

But, and this is a huge but, bonds will pay their interest and mature at $1,000 no matter what happens to their market value. The bondholder just needs to sit tight, let it happen and collect the interest and principal.

That’s asking a lot of most small investors. Most want to get out and guarantee a loss.

One way of preparing yourself mentally to “not fix what isn’t broken.” Know, before you buy a bond, how much you can expect to make from it, and what your worst-case scenario is before you invest.

This is where all the money will be lost or made.

Here’s a bond that’ll pay enough to keep most people in place and allow you to cash in on the panic selling in bonds of all types that has to come.

The Edgen Murray Corporation has a B-rated bond (cusip: 280148AC1) that’s paying a coupon of 12.25% (that means you get $122.50 in interest per bond every year). It matures in January of 2015. It also has a call date of January 2013 when the company has the option to buy back the bond before maturity at 106, or $1,060. If called we would earn a return of about 20% annually.

Besides the very high coupon of 12.5% and a 20% return to the call, here’s what I really like about this bond…

It has a maturity of about two and a half years. Short maturities are an absolute necessity to survive the coming panic selling that will accompany increasing rates.

When rates move up, a bond with this maturity will drop in value about one-third of what a 10-year maturity will. That will decrease the possibility of selling in a panic when you get your account statement and thus keep you in the black.

Staying put is absolutely essential! Cut and run and you become one of the losers.

The silver lining of very short maturities is that you’ll have fresh money coming out of maturing bonds to buy into a rising interest rate market. This is how you turn a bad situation into a big payday.

Waiting 10 years for money to come due when your market value is dropping is a Herculean task for anyone. Two years is a whole different story. It’s being able to see the end that makes it more manageable, and two years is manageable for anyone.

As this unfolds you’ll be buying bonds at pennies on the dollar, earning incredible annual returns, yes, higher than 13% and 20%, from bonds being sold at huge losses by uninformed investors.

So just like that, dropping bond prices just became a very big positive for your portfolio. The key though is you must be disciplined enough to ride out what will be a horrible storm for most. Ugly doesn’t begin to describe what will happen to long-term bondholders and panic sellers.

One of the most beneficial aspects of the Edgen Murray bond – and all bonds – is that before you put one cent into this bond you will know exactly how much you will be paid annually and at maturity. No guessing!

This is the one part of bonds that will make riding out the coming storm easier. And it’s one more psychological edge we have helping us stay put during the coming sell-off.

MEAR: Minimum Expected Annual Return

So how do you figure out your return beforehand?

I use an equation I call MEAR, or minimum expected annual return.

Here’s the MEAR for this bond:

Edgen Murray Corporation Bond:          

  • Rate = 12.25
  • Maturity = 01/15/2015
  • Price = 101.500 (Think of this as a percentage of $1,000)

This bond will pay us six interest payments of $61.25 per bond on January and July 1 until maturity in January 2015.

5 x 61.25 = $306.25

There’s a slight premium for this bond of $15 – it’s selling for about $1015 – so we must deduct that from our total interest payments.

$306.25 – $15 per bond = $291.25

We’ll hold this bond for about 30 months so we divide our total, $291.25, by 30, and divide by our cost of $1,015 per bond.

$291.25 / 30 / 1015

Times 12 for a one-year average.

$291.25 / 30 / 1015 x 12 = 11.48%

Yes, 11.48%! Whether the bond’s market value goes up or down.

Right now, defaults in all corporate bonds, investment grade and high yield, or junk bonds, are about 1% to 3%. That means 97% to 99% of corporate bonds are paying exactly as promised. That’s a huge advantage over stocks and a bet that makes this a possible play for almost everyone.

So, the most probable worst-case scenario for corporate bonds (97% to 99% of the time anyways) is you hold them to maturity, collect your interest and get your $1,000 in principal back no matter what the market does.

I can do that, especially when I’m earning 11% -plus per year for waiting it out.

The keys to this strategy are disciplined buying, understanding what’s really happening, knowing before you buy a bond what you’ll make, and that you may have to hold it to maturity. If you’re making enough from your bonds and prepared for the volatility, that should be easy.

Remember, when interest rates hit the fan:

  • Own short maturities in companies with good fundamentals.
  • Sit tight when bond market values drop.
  • Collect your interest and principal.
  • As your bonds mature buy back into the market’s rising rates and lower prices.
  • Finally, laugh all the way to the bank.

Good Investing,

by Steve McDonald, Investment U Research

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