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Bond Investing

What You Need to Own If This Turns Into a Real Bear Market

In the last bear market from October 9, 2007, to March 9, 2009, there were few places for an investor to hide.

U.S. large cap stocks declined 53%. International stocks declined 61%. Real estate investment trusts declined 17%. Commodities declined 48%.

U.S. bonds went up 16%, however.

This was not an exception. This is the norm. The asset class that has performed most consistently during bear markets is high-quality bonds.

According to Morningstar, bonds gained during all but one of the 28 bear markets since 1929. In that one bear market when they didn’t go up, they lost less than 1%.

Yes, yields are low right now. But prior to yesterday’s Fed announcement, many investors were so scared of a pending rate hike that they avoided bonds altogether.

That is not a smart strategy. Opt for cash instead of bonds and you are looking at a minuscule yield and a guaranteed negative return after inflation.

True, high-grade bonds work like a seesaw. If interest rates go up, the price goes down. If interest rates go down, the price will go up.

(That’s because a lower-yielding bond has to drop in price to make it attractive enough to compete with new bonds at higher yields. Otherwise it would be illiquid. By the same token, bonds rally in price as interest rates drop to bring their prices in line with new offerings.)

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And there is no guarantee yields are going up more than a quarter of a point anytime soon.

The performance of bonds going forward may surprise you. When the Federal Reserve took short-term rates to zero in the fall of 2008, no one was predicting that rates would still be that low seven years later.

Yet they are. And rates could stay low a lot longer, especially since the futures markets are indicating that inflation will remain negligible for the next 10 years.

Sounds unlikely? Think again. Add up slow economic growth, stagnant wages, a strong dollar, global outsourcing, cheap raw materials and plunging energy prices and see what you get.

If you are leery about bonds right now, there are a few steps you can take to reduce your risk.

  1. Buy individual bonds. Buy a bond fund and there is no guarantee you will ever get your principal back. Not so with individual bonds, which come with a maturity date and a corporate or government guarantee. When your principal comes due, you can always reinvest it at higher rates. (Assuming, of course, that rates are higher then and not lower.) Plus, individual bonds don’t have annual expenses. All fixed-income funds do.
  2. Stay with maturities of five years or less. Longer-term bonds are far more volatile than short- to medium-term bonds since the maturity date may be decades away. Shorter-term bonds will fluctuate less and return your principal to reinvest sooner.
  3. Know your bond or bond fund’s duration. Duration is a measure of this interest rate risk. For instance, a bond with a one-year duration would lose only 1% of its value if rates were to rise 1%. A bond with a duration of 10 years would lose 10% if rates were to rise by the same amount.
  4. Consider tax-frees. Right now a 10-year muni yields essentially the same as a 10-year Treasury. But the after-tax difference can be huge. The case is even more compelling if you live where there is a hefty state income tax as well.

I share your disappointment with the current yield on investment-grade bonds.

But if the unpleasantness in the market evolves into something more serious, history suggests that this will be the best-performing asset class in your portfolio.

Good investing,

Alex


About

An expert on momentum investing, value investing and investing based on insider activity, Alex worked as an investment advisor, research analyst and portfolio manager on Wall Street for 16 years. He now runs the wildly successful Oxford Communiqué, ranked as one of the top investment newsletters by Hulbert Digest for more than a decade. He is also the author of four national best-sellers: The Gone Fishin’ Portfolio, The Secret of Shelter Island, Beyond Wealth and An Embarrassment of Riches. He shares his wisdom in his free daily e-letter, Liberty Through Wealth.

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