Article by Investment U
When interest rates rise, many bond investors will get slaughtered. Protect yourself from the coming bond market collapse with this new investor's guide.
The so called “flight to safety” that’s going on right now is more like a mad dash to insolvency.
Macro-economic pressures worldwide have created a rush to any “secure” investment. U.S. treasuries and the German Bund are the favorites, but all bonds have been under huge buying pressure.
This massive money shift from risk to so called “safety” has driven up prices of all debt – not just U.S. and German sovereign debt – to levels most of us have never witnessed.
When the 10-year dipped below 2% several weeks ago the entire money world took a collective step back. The resounding response from the street, “Is this really happening?”
As I am writing this the 10-year treasury is now below 1.5%. Yes it is happening!
Paying Premiums No One Ever Dreamed Possible
For those of you who may not understand bonds as well as other parts of the markets, when the prices of bonds go up, the yields come down. Right now we are paying prices for bonds that border on ridiculous. At 1.5% on the 10-year treasury investors are paying premiums no one ever dreamed were possible.
Does anyone remember what happened to housing prices and the stock market in 2008 when those prices were ridiculous?
That’s right! It has to happen here, too.
Before I get too far into the Armageddon awaiting buyers of treasuries and other interest rate sensitive investments that are paying record low rates, let me assure you, there are ways to own bonds and ride out the coming debacle… and still make money.
When rates move up there is however, no way to avoid a drop in the market values of all bonds and interest sensitive investments. All bonds will take a hit when this downward trend in interest rates reverses.
How much of a hit you take and how much you make while you ride out the storm is the real issue. Holding bonds when their market value is down is no big deal if you are making enough on the minimum expected annual return (MEAR) to make it worth the wait.
Investors who are buying into this flight to safety in U.S. treasury bonds that are paying 1.5% and less will be stuck at 1.5% probably for the full maturity – 10 years.
1.5% for 10 years! Are you kidding me? That’s worse than a bad marriage!
The worst part of it all is the drop in the value of treasuries. When rates run up and bond market values drop it will scare most holders to sell at losses… big losses. The first time a monthly statement shows a big drop in value in what most assumed were guaranteed investments, most will sell. Believe me; they will sell as if their bonds were on fire.
Losses in Treasuries? You bet!
If you sell any bond before maturity you only get the market value. Any bond! And a 30-year treasury will lose as much as 35% to 40% of its market value with a three-point increase in rates.
Three points may sound like a lot but all treasuries were paying three points higher in November 2007 and the 10-year was above 5.3% in June 2007. That’s almost four points higher than it is now.
This drop in bond prices has to happen and it’ll be a blood bath!
Where’s the Safety?
By now I hope the idea of holding a bond for 10 years at 1.5% seems ridiculous. When you consider how much you can lose in treasuries just in the dip in market value, and how much potential income you lose over 10 years at 1.5%, you have to be asking yourself, where’s the safety?
When you look at the money reality of 2.5% on the 30-year treasury and 1.5% on the 10-year, how can what’s happening be considered anything but a flight to poverty?
If treasuries were paying 8% or 10% I could justify holding them and riding out the rough spots, and riding it out is the only way to make money during the correction that’s coming.
How to Ride it Out
If you discipline yourself to own short maturities, stagger your maturities by having at least one bond maturing each year, and own small positions to gain the same advantage diversification gives you in stocks, you will have done all you can to limit your downside when rates run up.
But short maturities are a double edged sword. The shorter the maturity the less a bond will drop when rates run up. But shorter maturities also pay lower interest rates.
That’s why it’s a real balancing act to make this work.
The solution is to buy bonds that have a little lower credit rating. Companies that are still good credit risks, but ones that Wall Street typically avoids – considering they stick with mainly AAA and AA bonds.
AAA corporate bonds pay less than 1%. No one will sit on a bond at 1% when rates start to move up.
But for instance, one bond that I’ve had my eye on is a BBB+ rated bond from Morgan Stanley (cusip: 61748aae6). The bond pays around 5.1% for less than a two-year holding period. Its maturity is April 4, 2014.
A 5.1% rate isn’t huge, but the maturity is short enough that you won’t see a huge drop in value when rates move up. Plus, you’ll be getting your principal back in less than two years to buy into a rising rate market and it’s almost 10 times what you’re getting in money markets.
The biggest selling point for this bond is it’s BBB+, investment grade! The credit quality should be good enough for almost any portfolio.
And if you’re willing to take on a bit more risk, there’s even more lucrative opportunities… two of which I share with Investment U Plus subscribers in today’s issue. (red text only for IUD versions)
What You’ll Gain From This Method
But by staying disciplined with short, staggered maturities in lower rated bonds, you’ll be able to:
- Limit your downside risk due to interest rate increases.
- Return your principal in a short amount of time and make cash available to buy into a rising interest rate environment.
- Pay far above what other bonds are earning or will earn.
- Limit your market exposure by limiting how long your money is in the market.
- And most importantly, pay you enough to allow you to ride out the storm and not sell at a loss when rates start to move up.
This whole scenario is based on the assumption that if you earn enough in your MEAR, market fluctuations don’t matter. Most bond investors are very comfortable riding out a spike in interest rates if their portfolio continues to return above market rates.
Like I said, it’s a balancing act. But, if you plan on staying out of the stock market’s insane volatility and still make enough money to survive, you will have to do some balancing.
Short maturities, staggered maturities, small positions… that’s how you’ll be able to ride this out.
Good Investing
Steve McDonald
P.S. We’ve been inundated with e-mails from our readers who don’t want to risk their retirement in the current market – and I don’t really blame them. So in just a few weeks, I’ll be initiating a new trading service aimed at safely and successfully investing outside of the stock market.
But in the meantime, I’m providing Investment U Plus subscribers with two more viable bond options (along with cusips) that fit my criteria for of short, staggered maturities with interest rates ranging from 9.14% to 14.7%.
To receive these recommendations along with other daily picks from our team of experts, click here to learn more about subscribing to Investment U Plus.
Article by Investment U
