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Tuesday, August 13, 2013

How to Play the Coming Bond-Market Rout

Bull Itch
Bull Itch (Photo credit: emilio labrador)
By Investment U

Washington, Aug.13, hot stocks .- You know it's coming. Every experienced investor who is paying attention knows it's coming. I'm talking about the upending of bonds that will take place in the months and years ahead. However, there is a smart, low-risk way to play it... and earn a decent return.

Let's start with the basics. Picture a seesaw with interest rates on one side and bond prices on the other. When interest rates go down, investment-grade corporates and Treasuries go up. When interest rates go up, these same bonds go down.

Why is this so? Think about it. If new bonds are coming out with higher coupons, your old bonds must fall in price so that the yield rises to what new ones are paying. If that weren't the case, your bonds would be unsalable. After all, no one voluntarily buys similar (or identical) bonds with lower yields.

Let me concede that ordinarily I am not a stock or bond market timer. But I take off my "market-neutral" cap under certain unusual and well-defined circumstances. In the stock market, it's when values and sentiment reach extremes.

For example, when low valuations combine with great fear and anxiety - as they did in the depths of the recent financial crisis - you can buy with confidence, content in the knowledge that this is virtually always a superb long-term opportunity. And when high valuations combine with optimism and euphoria - as they did in the housing bubble six years ago or the Internet bubble 13 years ago - you need to pare back or get the heck out, confident that history shows these situations always end badly.

There are two reasons that this is one of those rare times in the bond market.

The first is that we are at the tail end of the greatest bull market in bonds in more than 100 years. Too many fixed-income investors are either naive - looking solely at historical returns - or complacent. From the peak of interest rates in the hyper-inflationary early '80s, interest rates have now declined to the point where most investment-grade bonds offer a prospective negative real return. (In other words, your return after inflation is likely to be less than zero.)

The other reason is that the Federal Reserve, in its attempt to goose the economy, has distorted the fixed-income market. Recall our seesaw. When the Fed buys bonds to keep mortgage rates and other long-term rates artificially low, it does it by driving bond prices artificially high.

Do you really want to own a low-paying asset that the federal government is temporarily pricing high? I didn't think so. That's why you should minimize or eliminate your exposure to long-term bonds. Those are the ones that will be hurt the most when interest rates rise.

But don't abandon the bond market altogether. You should still own high-yield bonds and inflation-adjusted Treasuries. And with your high-grade bonds, tweak your portfolio by moving into shorter-term maturities.

Yes, even these bonds will decline in price when interest rates go up, but not by much. Let me give you an example.

Call or check online to find out the average maturity of your bond funds' holdings. This is called the duration. If a fund has a duration of three years, for instance, it will decline 3% if interest rates rise one full point. If the duration is two years, it will decline 2%.

But a full percentage point rise is pretty big. And, remember, this temporary decline in price will be offset by the interest payments (or bond fund dividends) you receive.

Investors who are shifting to money-market accounts that pay essentially nothing to avoid the looming bear market in bonds are making a mistake. If the rise in rates is slow and steady - a good bet since inflation is low with commodity prices soft and wages stagnant - or a long time in coming, you will make out better in short-term bonds.

So don't flee the high-grade, fixed-income market. Just adjust your fixed-income portfolio by shortening the duration.

After all, successful investing is about managing risk, not running from it.

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