The Quest for Yield (Part 7): What about Bonds?

The biggest risk for most investors is one they are not even thinking about:  Bond funds, the black swan of 2012.

Individual investors are on a mission.  The cry comes from everywhere:  Give me yield!

Scared witless by the housing bubble, the stock market decline in 2008, and the continuing headlines, the average investor makes the mistakes that come so naturally:

1. Chasing past performance -- bond funds have done well.
2. Confusing true yield with current payouts -- many "yield plays" are simply returning your capital.
3. Failing to balance risk and reward -- yield history provides a false sense of security.

These combine to create a false sense of security about investments in bond funds.  Many investors, despite the warnings in the prospectus, think that these are safe investments with assured yield.

Not so!

The Risk in Bond Prices

Whenever you buy a bond, the price is determined by current yield.  If interest rates move higher, the bond price must go lower to generate the new market yield.

Anyone who does not understand this relationship should not own a bond fund.  You can get badly burned.  One of my best friends owned bonds on the 70's when rates spiked.  He lost a fortune and explained that he would never buy bonds again.  (This was before my investment advisor days.) We can all see that it was the wrong lesson.   Bonds were a great investment just at the moment he was selling!  It is pretty much the opposite of the current market.

How to Think About Bonds

To start the process here are three questions:

1. What do you expect the inflation rate to be over the next ten years?  How about next year?
2. If inflation increases, what do you think will happen to interest rates?
3. Do you need any of your funds within ten years?

Let us suppose that you want to be super-safe, so you have joined the crowd in buying the (formerly AAA-rated) US Treasuries.  Let us take the benchmark 10-year note as our example.   If the interest rate moves from the current 1.61% to 2% you will have an immediate capital loss of about 3.5%.  If the rate moves to 2.5%, your loss is about 7.8%.

And we are just getting started.

You will not have capital losses if you do not sell the bonds, but what if you are in a bond fund?

The Rules of Bond Funds

The problem with bond funds is that you cannot control when the selling occurs.  If there are redemptions, the fund is forced to sell, even if losses are locked in.  Since we have had a multi-year run of inflows to bond funds, no one thinks about the dark side.

You will never hear about this risk from bond fund managers (think Pimco, whose employees all seem to follow the party line) or researchers that work mainly for bond guys (Bianco).  These guys have only one product to sell, so you will never hear a valid comparison of stocks and bonds on a risk/reward basis.

Objective Sources

Over the years a number of readers have commented along the lines that people like me are trying to sell stocks.  The most aggressive of these have called me a "shill" for the sell side firms.  I understand that some of these are paid trolls, and I usually only make one polite response.  It is a bit aggravating because it is so wrong.

The truth is that independent investment advisors profit only when their clients do.  We are completely aligned, attempting to find the best asset allocation.  I start with each new client by asking whether we are attempting to preserve wealth or to create wealth.  I manage six different programs including bonds, stocks, ETFs and alternative investments.  The right mix differs by client.

I have new clients -- right now -- for whom a major emphasis on bonds is correct, so that is what we do. This is completely unlike the "expert" you see on TV who makes his money exclusively by selling gold, or stocks, or annuities, or bonds.

My Chicago colleague and friend Brian Gilmartin provides similar advice on asset allocation.  He covered the topic in fine fashion in this recent article on his new blog.  It is a good illustration of how a first-rate manger tries to incorporate bonds for clients.

An Alternative Concept

I have a different approach to bond investing.  It is strong, and working well.  Here is the mantra:

Buy bonds, not bond funds!

My approach is a bond ladder.  See if you qualify.

• A strong focus on guaranteed return;
• No immediate need for the principal;
• Desire to participate as rates move higher;
• Willingness to accept a modest yield.  (If you need more, you should be in our enhanced yield program described in Part 6.  It is an individual matter.)

A bond ladder meets these objectives.  The exact specifications can vary but my rules are as follows:

• Five "rungs" with three bonds per rung;
• Everything is investment grade with no company on negative watch;
• Only one bond per company;
• Careful shopping on entry to get the best prices (which affects the yield);
• Ability to "roll" to higher yields if/when rates move higher.
• The investor has fifteen different high-grade bonds with very little risk and the ability to ratchet up yield over time.

When we get paid on a maturing bond, we reinvest at the long end.  We are not at the mercy of other investors who may not share our interest.

Why is this Special?

Why is it that every investor is not doing this?

It is a bit tricky.  Most investors are comfortable buying stocks, but they do not understand how to buy bonds.  There are some tricks and traps.  It is well worth learning, but it takes a little work.  It is a complex subject.  I have new clients building current bond ladders, and I'll provide some specific examples in future articles.

Meanwhile, I want to highlight a great educational site about bonds.  If you are interested in fixed income, you should set aside some weekend time to explore the many great ideas at LearnBonds.com (now added to our featured sources).

Conclusion

If you own bond funds or bond ETFs you should conduct an immediate review.  Taking personal control of your bond allocation requires owning bonds, not bond funds.

 

 

 

Comments

[Fabian]

There is another problem with bond funds; the dilution. All the new money that comes in must be invested at today's prevailing interest rates and unrealized capital gains are diluted by the new money. You don't really profit of a successful timing decision.

[oldprof]

Andrew -- My selection method is geared to identifying stocks with reasonable dividends and payout ratios, at least somewhat undervalued, and with some reason to think there is a base.

I am not projecting or promising any return from price improvement in the underlying stock. So far the double-digit return has come from dividends and call sales, with the stocks breaking even.

There are many ways to pursue this strategy. I understand that others have greater emphasis on the stock or the call sale.

I hope this answers your question, and I wish you luck with your variation of the approach.

Jeff

[Andrew]

Thanks for your great post.
I checked out quite a few of your other posts and am impressed your analysis.

Question:
Is the sweet spot for covered call stock selection buying solid balance sheet/good cash flow companies with a history of paying a growing dividend (and a payout ration say less than 70%) during times when implied volatility may be higher (such as now) - so valuations for the stocks you are writing calls on are lower - despite being solid companies.
The sweet spot for the calls themselves is about where you can earn 1-2% a month on top of the dividend and such that there is 2-4% of upside potential?

[Steve]

Jeff,

Looking forward to learning more about the "tricks and traps" of buying bonds. Thanks

[oldprof]

woolybear1 -- I do not want to make specific recommendations about funds.

Having said this, Jeffrey Gundlach has a great record and is always worth listening to. He has done well at avoiding some bond market pitfalls. If and when we get a rising interest rate environment, it will be a new challenge.

Implicit in your question is that if you are not going to take my advice and learn to buy your own bonds, you might at least look for the best manager:)

Good point!

Jeff

[woolybear1]

Jeff, what is your take on Grundlach's Total Return Bond Fund? thanks

[oldprof]

scm0330 -- Selling puts in the way you describe is a perfectly acceptable strategy when you are willing to own the stock and you choose the appropriate size.

It got a bad name in 1987 when many people sold puts in excessive size. The size was chosen based upon how much income people wanted rather than how much stock they could afford to buy! So many were burned that the rules were tightened up.

The strategies also differ a little in what stocks you choose. I go for a different group in this program than in my more aggressive long-term growth program.

This is fine for a sophisticated and agile investor.

Jeff

[oldprof]

Jonathan -- Yes, I have looked at the BulletShares. Since you still do not have control, I do not like that strategy as much, but I agree that it is a middle ground.

It could be a good alternative for some.

Jeff

[oldprof]

Thanks, Lou.

As you can see, I think it is important. More later.

Jeff

[oldprof]

Proteus -- You need to buy bonds at a $1000 minimum, so if you want three bonds per rung you are starting at $15,000. You also will pay accrued interest since the last coupon payment (which you will get back at the next payment) so the price is a bit higher. Probably $20,000 is the practical minimum. You could go with fewer bonds per rung, but you lose diversification.

Jeff

[scm0330]

Jeff,

I toggled over to your post on covered calls. Question: have you considered using cash-secured puts as part of an income strategy? Using the same pre-existing criteria as in your calls program [e.g., high-grade stocks, dividend payers, names you're comfortable owning long-term], why not sell puts against your cash position.

I target 2-4 months to expiration, and a 10% annualized income return.

The obvious risk is a stock and/or market break that results in owning a stock below the strike level. But to take CAT as an example, I'd rather own it by getting assigned an Aug $77.50, regardless of where it's trading at assignment, as opposed to riding down the next 10 points on my long holding from current levels.

If I get assigned, I can revert to selling calls similar to your program.

What's more, I can be more flexible in where to deploy my free cash as positions expire without assignment, seeking opportunities for the money [i.e., where there's been volatility, and premiums are juicy].

Curious as to your thoughts.

[Proteus]

Jeff, what's a reasonable minimum to implement this strategy? For a hypothetical $5000 stock portfolio, I could buy $1000 worth of 5 issues and probably do OK, and not even raise too many eyebrows. How would one do this with individual bonds?

[Jonathan]

Hey Jeff - Have you looked at using ETF's with maturity dates as a middle ground? Guggenheim BulletShares corporates as an example?

[lou]

Jeff, you have offered world class investment advice in this piece! All should take notice.