From the January 2011 issue of Research Magazine • Subscribe!

Time to Leave Bonds?

In his famous hit song “The Gambler,” Kenny Rogers explains you got to “know when to hold ‘em, know when to fold ‘em.” But knowing the ideal time to exit a game of cards or a trade or an investment is something everyone would like to know, not just gamblers.

Given that bond prices have surged and yields are slim, is it time to ditch bonds?

Today’s bond market favors sellers, not buyers. Knowing this, U.S. corporations, like the government, have been issuing new debt in the form of bonds at a record pace.

Around $332 billion in corporate debt has been issued during the third quarter alone. Even companies with a spotty credit history are having an easy time finding buyers for their debt. As borrowing rates have dropped, prices for junk bonds (HYG) over the past year have jumped 14.85 percent.

Moody’s Investors Service estimates the default rate on high risk U.S. corporate bonds will decline below 3 percent by year’s end. Their default rate tracks the percentage of companies with junk rated debt that missed bond payments during the preceding 12-month period. During the final half of 2009 the default rate was at 14.60 percent.

Even with today’s lower default rates, the corporate borrowing binge will eventually have a cost. All of the record debt that companies are racking up today will have to be paid. And as Warren Buffett once quipped, “Debt is a four-letter word.” 

Accepting Low Yields

During the fourth quarter, the U.S. government had no problem selling $36 billion in two-year Treasury notes yielding just 0.441 percent. Oddly, record low yields didn’t faze bond buyers one bit. And so long as the U.S. government can obtain cheap financing from eager buyers of its debt, it can continue running up multi-trillion dollar deficits without incident. 

Short-term government bonds (SHY) with maturities of 1-3 years have a 30-day SEC yield of just 0.26 percent. In contrast, investment grade corporate bonds (CSJ) with similar maturities are yielding almost 90 basis points more. The SEC’s yield calculation takes into account the interest earned during the most recent 30-day period after deducting the fund’s expenses.  

The mentality of today’s bond investor has drastically changed. The traditional view of investing in bonds for yield income has been replaced by investing in bonds for capital protection. Meanwhile, little thought has been given to interest rate risk and issuer credit risk.

There are many warning signs in today’s overheated bond market. Record low yields favor debt sellers, not debt buyers. Also, increasing debt loads for both corporations and the government will come back to bite them and the individuals that financed them once the current cycle of over-borrowing fizzles out. No doubt, most of Wall Street’s credit analysts and bond underwriters are still forecasting blue skies ahead. Should we expect anything less?

If your clients have enjoyed the run-up what should you do? Evaluate their portfolio to see if certain bond positions have suddenly become a disproportionately large part of the portfolio and rebalance the bond portion back to its original target asset allocation.

How else can advisors help their clients to maneuver around the potholes? Here are a few rules of thumb to consider:

The history books of “safe bond investing” will likely be rewritten, so invest accordingly. For example, in response to the Federal Reserve’s announcement of its second round of quantitative easing or “QE2”, the China-based Dagong Global Credit Rating Company downgraded the U.S. government’s credit rating to negative outlook.

“The potential overall crisis in the world resulting from the U.S. dollar depreciation will increase the uncertainty of the U.S. economic recovery,” stated Dagong. “Under the circumstances that none of the economic factors influencing the U.S. economy has turned better explicitly it is possible that the U.S. will continue to expand the use of its loose monetary policy, damaging the interests the creditors. Therefore, given the current situation, the United States may face much unpredictable risks in solvency in the coming one to two years.”

Despite Fed officials’ desire to keep long-term interest rates low, their plan may not pan out. The yields on long-term Treasuries have risen over the past few months. The iShares Barclays 20+ YR Treasury Bond Fund (TLT) is yielding around 4.07 percent around 0.60 percent higher over the past few months.

Get and stay diversified. Warn your clients about the danger of investing in individual bonds, especially individual municipal bonds. Many states and local municipalities are in deep financial trouble. Bond defaults will likely result in interest payment interruptions and badly damaged bond values. Are today’s paltry yields really worth the hidden credit risk? Avoiding single issuer blowups will be one key to thriving when the bond market is shaken.

A much better strategy is to anchor your client’s investment portfolio with a diversified core bond fund like the Vanguard Total U.S. Bond Market ETF (BND) or the iShares Barclays Aggregate U.S. Bond Index Fund (AGG). These types of funds focus on a diversified mix of top-rated investment grade debt from both government and corporate issuers.

Hedge bond risk. Besides being diversified, consider buying protective put options on your clients’ bond ETF holdings as temporary insurance. The basic idea behind this strategy is to offset portfolios losses with a corresponding gain the value of put options. If we buy insurance to protect our valuable assets like our homes, cars and lives, why wouldn’t we do the same thing with another valuable asset — our investment portfolio?

Look for opportunities and capitalize. As interest rates inevitably head higher, bond values, particularly for longer-dated bonds will suffer. Look for ways to capitalize on this trend. One strategy might be a short-term strategic trade like the Direxion Daily 30-Year Treasury Bear 3x Shares (TMV) that aims to profit from a fall in the price of long-term Treasuries.

Conclusion

Maintaining bond exposure via a broadly diversified low cost index fund is always a prudent investment strategy in any kind of climate. However, analyze your clients’ portfolios and help them to verify they have the right bond strategy. It should complement their portfolio’s overall design, not add unwanted financial risk.

Concentrated positions in individual bonds or bonds with long-term maturities should raise immediate red flags. Help them to see the problem before it becomes a problem and take corrective action. They will thank you for having foresight and caring. And you’ll feel great, because you did a diligent job.

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