Article by Investment U
The entire income side of the investment world has been so wrong about interest rates for so long that I’m beginning to believe this market will never get back to normal.
To give you an idea of how out of whack this market has become, consider this: Two years ago, the 10-year was in the 3.5% range and the whole bond world was predicting a run-up in rates from there. No one thought it could go down any further. Surprise!
Right now I’m looking for the 10-year Treasury to drop to the 1.1% to 1.25%. It’s currently around 1.5%. I see nothing going on that would drive rates higher in the near future – three to five years.
The worldwide charge to safety has driven any investment with any degree of stability or reliability to multi-century highs with multi-century low interest rates.
The incredible part of this, even at the ridiculously low rates we have now, is that money is still pouring into these same investments. There seems to be no end in sight.
Even munis, which are paying nothing, are seeing huge amounts of new dollars moving into them.
Driving this insane shift are four major factors, and all are big red flags.
- First, most small investors, or what the business calls retail investors, are still in shock following the massive losses most took at the bottom of the collapse in 2008 and early 2009. This retail investor still hasn’t returned to the stock market and is nowhere in sight.
- Second, these same investors have flocked to the traditional safe side of the house, dividend-paying stocks and bonds. Add to these numbers the investors who have always held these so-called safe investments, conservative or retired investors, and you have one very over-bought segment of the market.
- Third, as the EU moves closer to a default or reorganization, money from that market has poured into the same “safe” sector of the U.S. market.
- As unbelievable as it may seem, we now have a fourth element moving in the same direction – and this is the biggest red flag of all – investors willing to accept a guaranteed loss in the name of safety. They don’t know it’s a loss in the making. They see it as the last ditch effort to protect their money. But when these rates turn around, and they will, the market prices of most interest sensitive investments will crumble and the losses will be monstrous – not because of the bonds – but because of the people who own them.
Don’t Be a Rate Pig
Losses in mutual funds that hold long maturity bonds and are leveraged will have the worst losses, and that’s where most retail investors have their money. Leveraging and the long maturities produce the highest yields and the largest losses, and that’s what the little guy buys.
“Rate pigs” is the term used to describe this type of investor. Those who ignore or have no understanding of the effects of maturity or leveraging, and just buy the highest yield number.
Instant death! This is never a good idea, but in this market it’s just plain dumb.
There’s a strategy that will allow you to buy into the “safe side,” still earn a decent return, significantly limit the downside when these rates turn around and, if you structure the portfolio properly, make cash regularly available to take advantage of a rising interest rate market.
There is just one little problem. Well… really two.
- First, most investors have neither the discipline nor the bond understanding to make it work. They can get the understanding; the discipline is another thing entirely.
- Second, the investment required is a very specific type of bond that isn’t easy to find. They’re out there, but I spend several hours a day, five days a week looking for them and I am lucky to find two good ones a month.
A properly structured portfolio of these particular short-term, high-yield corporate bonds will pay you far more than what the stock market on average is returning – or leveraged bond funds. They hold their value better than almost all interest sensitive investments during a sell-off and they leave you a decent return after taxes and inflation take their bite.
I call it the “Any Market Portfolio.”
The Any Market Portfolio
Now, when rates turn around – I can’t guarantee that a bond with a two-year and three-year maturity won’t see any drop in market value – it shouldn’t be enough of a drop to panic you and make you sell at a loss.
You see, it isn’t the bonds that have or will have problems; this type of bond in this market has a 97% success ratio. It’s the people who own them who are the problem.
People who own bonds will do all the wrong things when rates start to run up, namely sell at a loss, and that’s where the blood bath will begin.
Using the Any Market Portfolio can help you over the rough spots, get you to the point of making a very good return and keep you out of all the usual minefields that only create losses.
Using this portfolio strategy successfully will require you do few things differently:
- Have at least one bond per year maturing. That will make cash available on a regular basis to buy into a rising interest rate market.
- Own only ultra-short bonds. That’s a maximum of an eight-year maturity. That will limit the downside and hopefully keep you in the game when the market starts to sell off.
- Buy small positions. It’s one thing to watch a $5,000 investment drop in value. It is an entirely different picture to watch a $50,000 one dropping. It’s a head game I know, but it works.
Even in this market, there’s a lot of safe money to be made in bonds, but it’ll require you play by a few new rules. You can be on the “safe side,” but you have to own the right bonds and recognize that at some point their market value will drop. Then you have to have enough market sense to know that selling at a loss only benefits you at tax time.
The “Any Market Portfolio” isn’t perfect, but it will allow you to stay in investments that have a high degree of predictability and reliability, and turn the eventual sell-off in bonds into a big payday.
Sounds like magic, but it isn’t. It’s just good old-fashioned applied money sense with a lot of buy and sell discipline.
Unfortunately, that’s exactly what most people don’t have, a sound buy and sell discipline.
Good Investing,
Steve
Article by Investment U
