Since bond prices and interest rates move in opposite directions, the risk in the bond market is that rates move higher (they can’t move much lower!), which pushes bond prices down. This risk is much greater in a long bond than it is with a security that matures in just a couple of years. The Leuthold Group gives the example of a 20-year Treasury bond that sells for a 2.35% yield. The bond in question has a coupon of 5.625%. On a $100,000 original investment, it pays $5,625 annually. To buy that bond in the current low-yield environment, however, investors would have to fork over $140,240. (Yes. In the past few years, somebody has already made a 40% profit on that bond. And they are selling it to you.)
The bond has a price of $140.24. Should rates go back up by 1.65%, so the bond yields a more normal 4% yield-to-maturity, the price of the bond would decline to $117.10. If that rate increase happens over the course of the next year, the bond would fall nearly 19% in value. However, it would spin off income of about 4%, so an investor’s total loss would be about -15%.
While a 15% loss isn’t quite the same magnitude of losses that stock investors experienced during the technology bubble, for someone trying to be “safe” with their money, a 15% loss would come as a rude awakening as to the risk out there in the supposedly “safe” fixed income asset class. A novice investor might buy the bond thinking that they were getting a “safe” 2.35% return, only to get hit with a 19% loss, instead. A real rube might think that they were buying a bond that pays 5.625%, but experience that same 19% loss. In either case, buying a bond for safety, and then losing principal, isn’t going to make folks happy.
A 12-month Treasury bill, by comparison, would not lose money. However, the return on a 1-year T-Bill is only 0.17%. It’s almost as bad as losing money, since you’re loaning the money to the U.S. government to buy a lot of things that, well, you probably wouldn’t buy if you had a say in the matter.
We are shopping for reasonably short maturity fixed income investments that provide a better return than T-Bills. Heck - let’s face it - we’re just trying to find something that will give up a POSITIVE return for the next couple of years. And we’ve found five different types of securities that we believe offer both positive returns without taking a lot of risk.
In the past, we’ve been a regular buyer of short-maturity junk bonds ever since the high yield market blew itself up in 2008. With so much money being created by the Federal Reserve, we believe that it makes far more sense to take “credit risk” than it does to take on “interest rate risk.” The risk of default, we believe, is far lower than the risk that higher interest rates will depress the value of what we own. However, in 2008 investors could by short-maturity junk bonds with yields of 10% to 20%. These days, even on junk bonds, short-term yields may be more like 2% to 3% for most names. It’s tough to take any risk to principal when the investment return is that low. Still, in a few cases, we’ll buy short-term high yield bonds because we expect to hold those bonds to maturity. Rather than selling them, we can just let them mature. If the bonds are backed by hard assets, even in a worst case scenario we foreclose on assets that have value to investors.
Second, a little over a year ago we added a mutual fund that owns short-term government guaranteed mortgage-backed securities in its portfolio. The bonds aren’t backed by Fannie-Mae or Freddie-Mac, which are entities in guardianship currently because their overpaid traders and executives bought too much junk at the behest of Congress during the real estate bubble. Instead, we own mortgages that are fully guaranteed by the full faith and credit of Uncle Sam, just to be sure. Periodically, mortgage market participants blow themselves up by buying sophisticated securities on the premise that they’re a simple investment. In fact, mortgage-backed securities are easy to buy, but in a crisis they can be very difficult to sell. It happened after Orange County, California bought too many mortgage bonds in the early 1990’s, and again after the 2008 financial crisis. As a result, mortgages still offer reasonable returns, but they don’t belong in an individual’s portfolio as an individual security. They are just too hard to sell. For this reason, we invest in them through a mutual fund.
The fund we own has bonds in the portfolio that yield 3.09%. The fund’s 0.55% expense ratio must come out of this return. The fund’s price (net asset value) has been fairly stable. The N.A.V. was $10.62 in 2001, fell to $10.16 at the end of 2006, and is currently $11.29. We actually do expect the N.A.V. to lose some value, but not a lot. We’re hoping that our investment will earn 1% to 2% during our holding period. Also, it’s good to have funds around because they can be easily liquidated in the event we want available funds to use to buy long bonds later, after rates have gone up.
Another alternative we’ve started using is an exchange traded fund that owns a broad portfolio of short-term high-yield bonds. In this case, the bonds in the ETF all mature in 2014, so in two years we expect the ETF to self-liquidate and give us back our money. It’s similar to owning an individual issue, but with junk bond yields so low, it’s hard to justify taking much of any credit risk. By using a fund to diversify the investment, we reduce the likelihood that we happened to buy just the wrong bond, and lose a significant amount of principal in return for an insignificant rate of return.
The ETF we own has bonds in the portfolio that yield 5.39%. The fund’s 0.42% expense ratio must come out of this return. The fund is diversified across more than 100 individual securities, but trades easily throughout the day so it provides both diversification and liquidity benefits. In an economic downturn, we might want to sell these short-term bonds in favor of buying longer maturity investments. In the event of an economic recovery, presumably Treasury rates would move higher and we might want to lock in rates by purchasing longer maturity Treasuries. In the meantime, we’ll be paid a little to wait, and we hope to be able to have liquidity when the time is right to redeploy funds into different types of securities.
We have also found a few floating-rate bonds to be of interest. With interest rates so low, floaters whose interest rates are based on short-term interest rate indexes have plenty of room for their rates to increase when interest rates, generally, do start moving higher. In this case, it’s okay to buy a longer-term bond because the price should be protected (generally) by the increase in the bond’s coupon. Also, in some cases, the current interest rate is so incredibly low that the bonds are actually selling at a discount (i.e. below maturity value), so in addition to some modest coupon income, the bonds can be expected to appreciate as they move toward maturity.
A typical recent example is when we purchased the bonds of a too-big-to-fail bank which is paying IRA investors 0.55% to invest in a 4-year certificate of deposit. Although not insured, like a CD, the bank’s bonds pay a floating rate of interest currently set at 0.60%, and the bonds should appreciate from $89.4 to par ($100) between now and June 15, 2016. Combining the appreciation and the coupon interest should yield roughly a 3.25% return to investors. If short-term rate indices rise, the coupon on this bond goes up, which helps boost the ultimate return to investors.
Finally, there are a few callable bonds that are of interest. Callable bonds have a final maturity date, but they can be subject to early maturity at the whim of the issuer (i.e. they can be “called away”) based on current interest rate conditions. In this low rate environment, most callable bonds are called at the first opportunity because issuers can float new bonds, at lower rates, and use the proceeds to get rid of that old, high-coupon debt. It’s really not much different than what homeowners have been doing with their old mortgages. They take out a new mortgage and use the funds to pay off the old, higher rate debt.
The interesting thing about callable bonds is that they trade to the short-term call date. A bond with a 4% coupon won’t have much of a premium because buyers know that the bond will likely be called in a year or two. However, if rates increase between now and the call date, it’s possible that it won’t make sense to pay that bond off early, after all. In that case, the 4% coupon might last a lot longer than originally thought. The key is to find bonds with coupons that are high enough to be attractive, if kept to maturity, but low enough that it wouldn’t take much of an interest rate increase for it to no longer make sense to call in the bonds.
In today’s bond bubble, with the demand for bonds so much higher than the current supply of new bond issuance, it’s a very difficult place to find value. Hopefully the securities we’re buying will give us a 2%-3% return without exposing us to a lot of interest rate risk. We’re looking forward to the day when fixed income investors are no longer treated with contempt by the central banking system, which is looking to retirement savers to subsidize the mistakes made by the central banks and Wall Street bankers during the period leading up to the financial crisis.
In this environment, it’s good to be timid. It may not pay a lot, but it will likely pay off in the end.
Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies .
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