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Boston, Apr.16, online stock trading .- The party in bonds is not over for income investors. It's just getting started!
Goldman Sachs (NYSE: GS) released a report this week that said interest rates have to move up significantly in the next few years - and, best of all, the run will start this year. The report also stated that the pressures that have held rates so low for so long are gone and the market is set to move.
If you have been reading and listening to financial pundits, that may sound like bad news. But if you rely on income from your investments, this is the best news in half a decade.
For the last 30 years, with the exception of 1994, bond prices have been going straight up... and yields have been going straight down.
If you were trading bonds during this period, which virtually no one but banks and institutions do, you would have done very well. If you had to rely on the income from your investments, as most of The Oxford Club members do, it has been a low, single-digit interest rate nightmare.
That's all about to change.
But you have to be prepared for the shift, or you stand a very good chance of becoming one of the victims of the panicking herd.
Being prepared is simple.
Get out of anything, bonds or bond funds, with a maturity or average maturity of more than seven years. Plus, have at least one bond maturing each year for the next five to seven years - several per year is even better.
The short maturities will hold their value as rates move up. And having money coming due every year will allow you to buy into rising rates. This will limit the damage increasing rates will have on your holdings and give you the cash to buy bonds with much higher yields.
And "high" may be an understatement for how high yields could go.
Right now, there's a Bristol Myers bond with a coupon of 7.15% that is selling for about $1,386.25 per bond. It matures in June 2023.
At that price, this bond yields 2.58%. The yield is so much lower than the coupon because the bond only returns $1,000 (or par) at maturity. In other words, each bond comes with an instant $386.25 loss.
The yield breaks down like this:
- 21 interest payments of $35.75 apiece in June and December of each year.
- Minus our premium of $386.25 per bond.
- Divided by our cost of $1,386.25 and our holding time of about 122 months.
- Times 12 for an annual return of about 2.58%.
Waiting Game
But here's how the coming rising rate environment can really turn on the juice.
If rates only move up two to three points, the 10-year Treasury would be at about 3.7% to 4.7%, which is a very reasonable move. When it happens, the price of the Bristol Myers bond could easily drop to par - again, that's $1,000.
That's a 28% loss! You can why folks holding long-maturity bonds will be crushed in the coming bond market.
But if you buy into the market as rates rise and prices fall, here's what your return would look like.
We will change our cost to $1,000 and eliminate the loss of $386 in our formula: 35.75 x 21 / 122 / 1,000 x 12 = 7.38%.
All the bond did was drop to par, and our return increased almost three times!
Buying the Panic
But when the herd finally realizes it has been holding the wrong bonds and panic takes hold, yields could take off like a rocket.
Let's assume over the next two years we see a big sell-off in bonds, and the Bristol Myers bond drops to around $900.
Here's how the numbers shake out: 35.75 x 17 + 100 / 98 / 900 x 12 = 9.62%.
Your yield has jumped from 2.58% to 9.62% by doing nothing but letting the bond market do what everyone knows it must do... sell off.
This correction in bonds will take place over several years. It will not be an instant drop. But it will provide lots of buying opportunities.
And if the panic selling I expect really takes hold, we could see prices much lower than those I quoted here. The returns will be huge!
Stick to the Strategy
The trick, of course, is what to do with your cash between now and when this scenario develops. That's where the ultra-short maturities - less than seven years - and bonds maturing every year for the next five years come into play.
Ultra-short maturities will hold their value much better in a sell-off than longer-dated bonds. That fact will be just enough to prevent panic selling, which is the key to success in bonds going forward.
You can hold a bond with a small loss for a year or two a lot more easily than one with a big loss for the next 10 or 20 years. It's a mind game, but it works.
The greater price stability of shorter bonds combined with fresh money coming due each year to buy higher-yielding bonds will be the perfect combination to make money now and earn even more when bonds get really cheap.
No one knows exactly when rates will start moving up.
The recipe for success is simple... Sell your long-maturity bonds and bond funds. Use the cash to structure a portfolio of bonds maturing from 2015 to about 2020.
As the sell-off begins, expect your bonds to drop in value. But don't panic and sell! Hold to maturity and buy into falling prices and rising yields when your bonds mature.
Increase the maturity of your portfolio as yields rise. You want to hold big payers as long as you can.
The upward shift in rates will take time. There will be spikes here and there that will look like the end of the world. But ultimately the rise in rates will be a slow, multiyear process.
If you try to time it, you will lose!
The bottom line... you could increase your yield from 2.58% to 9.62% in one of the highest-rated companies in the world by doing nothing more than what our parents taught us so many years ago...
Be patient and plan for a rainy day. ...
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