Bonds 101

Bonds are classified into several categories and each has its different characteristics. Briefly, they are classified as 30-year Treasury bonds, 20-year Treasury bonds, 10-year Treasury bonds, short-term Treasury bonds, municipal bonds, investment-grade corporate bonds and high-yield (junk) bonds.

As of 5/2013, the long-term Treasury bonds are very risky. The interest rate is so low and it has no way to go but up. It will when the economy is improving. I do not expect that we will have zero interest rate for a long while.

Here are random comments on bonds.

·         Japan has almost virtually zero interest rate for a long while. If you borrow 1 M from them at almost 0% and invest in another country's bond at 8%, you think you win. However, you need to consider the risk in converting the country’s currency back to Japanese Yen, inflation, bond loss, and taxes.

·         In 2008, almost all assets lost. However, some high yield bonds (or junk bonds) made over 40% for 2009.  To illustrate, you bought these bonds yielding about 8% dividends in the beginning of the year. The government lowered the interest rate to stimulate the economy and hence the average yield was about 1% at the end of the year. The bonds you held yielding 8% was worth far more than the current bonds yielding 1%.

·         As of 4/2012, the interest rate is almost too low to invest in bonds to me.

Even the king of bonds made the wrong call. Do not bet against the Fed as they control the interest rate. 

Conventional wisdom tells us to balance your portfolio with a combination of bonds and stocks in proportional to the risk tolerance, which for some is determined by their ages. I prefer the reward/risk ratio and only buy bonds when interest rate is expected to fall which usually occurs after the first six months of a market plunge. The government has stimulated the economy by lowering the interest rate in almost all recessions.

As of 4/2013, the bond crash seems to be coming. When the economy improves, the interest rate will rise. The interest rate is so low now that it has no way to go but up. It will affect adversely to the bonds you’re holding especially the ones with low interest rates and long maturity from today.

If you have not got out yet, it could be your last chance. Even if it will not crash, the risk/reward is too high for me. You have been warned. If you read this article after the crash, check how much you have lost, learn it, and be smarter next time. If you have made some money by not following my advice, check whether the extra money is worth it for the risk.

If your guru tells you to stay with bonds this time, check his agenda and find another adviser if I am 100% correct.

·         As of 4/2013, cash could be a very good alternative to avoid the risky market and the poor bond prospect. You may lose due to taxes and inflation, but you're buying insurance. Move back to stocks when the reward/risk is higher.

·         The government bond prices could collapse when its issuing country is printing too much and depreciating its currency.

A bond at 30% yield may not be good if the company/country has more than 50% chance to default on their bonds.

·         These holding the GM bonds before the reorganization (i.e. the first bankruptcy) lose more than 40% of the bond values. Corporate junk bonds (i.e. high yield bonds) have its risk.

·         The muni bonds are risky to me. I do not really care about the small tax advantages. Some default. If you really want to buy them, use a bond fund to spread out the risk.

·         The long-term bond price moves in the opposite direction of the interest rate. It is about a 1 to 5 ratio by my rough estimate. If the interest rate moves 5% up, then the bond price would moves 25% down. It is very rough estimate as it also depends on how long will the bond matures (i.e. short-term vs. long-term).

·         Few sell the bond until it matures. If you need a steady income, buy the government bonds at an acceptable rate (for example, greater than 8%). 2012 is not a good year to buy bonds with the low interest rates. Some bonds did default and the owner lost most or even the entire investment. The GM bonds before its first bankruptcy is one of them though it is quite rare.

·         China has been a big player to buy US treasuries.

Chinese do not want to kill the goose that lays the golden eggs. They need a good economy in the USA in order to sell their stuffs, which would create jobs for their citizens and reduce their unrest and dissatisfaction on their government.

However, when your loan is repaid with the USD that is losing buying power, it is about time to switch to other assets including gold or ask your loanee to repay in gold instead of the USD. When the goose becomes meatless, it is time to slaughter the goose and make soup. Hopefully the USA will most likely be saved by the shale energy.

Afterthoughts

·         Bond ETFs: TLT (20+ years Treasury Bond) .

Contra Bond ETFs: TBF (Short of TLT). Click here for an article on contra Bond ETFs.

Click here for other bond and contra bond ETFs.

·         To respond to my ‘Edu-mercial’ (my new term) in 5/29/13, JTS said, “Very educational. Thanks! I'll be out my bond funds end of the day.”

·         Buying a bond fund and an individual bond could be quite different. Bond funds usually buy a large number of bonds maturing in different periods. The mature periods are according to the objective of the fund such as long-term bond funds.

·         There is a way to structure buying funds varying in maturity periods to lower the risk of the interest rate fluctuations. Check your broker to see whether they provide such a tool.

However, I believe it could be better to buy long-term bonds when the interest rate is high (say 8%). A 3% yield does not beat inflation (about 3%) even without including the taxes.

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My e-book Debunk the Myths of Investing could save you a lot of money in investing. The above is one chapter out of 105 and some important chapters will not be included in the blog.
  http://ebtonypow.blogspot.com/2012/12/special-debunk-myths-of-buffett.html

Sample portfolio for the book.
  http://stockportfolios.blogspot.com/2013/03/welcome.html

(c) 2013 Tony Pow

Disclaimer. I'm not responsible for your actions in your investment. Treat this as educational information and past performance does not guarantee future performance.