My A.B.C. on bonds
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 were very risky. The interest rates are so low and it has no way
to go but up. It will when the economy is improving. I do not expect we are
following Japan’s low interest rates for the last decades.
Here are random comments on bonds.
·
Japan has had almost
virtually zero interest rates for a long while. If you borrow 1 M from them at
almost 0% and invest in another country's bond at 8%, you may 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 money. However, some high-yield bonds (or junk bonds) made over 40% in 2009. To illustrate, you bought these bonds
yielding about an 8% dividend in the beginning of the year. The government
lowered the interest rates to stimulate the economy and hence the average yield
was about 1% at the end of the year. The bonds you held yielding 8% were worth
far more than the current bonds yielding 1% as most likely they provide better
dividends for the years to come.
·
As of 4/2012, the interest
rates were almost too low to invest in bonds.
Even the king of bonds made the
wrong call. Do not bet against the Fed as they control the interest rates. They
will raise the interest rates when they think the economy is ready.
Conventional wisdom tells us to balance your portfolio with a combination of bonds and stocks in proportion to your risk tolerance, which for some is determined by their age. I prefer the reward/risk ratio and only buy bonds when interest rates is expected to fall which usually occurs after the first six months of a market plunge. The government has to stimulate the economy by lowering the interest rates in almost all recessions. When the USD loses the reserve currency status, most stocks and bonds would be losers.
Conventional wisdom tells us to balance your portfolio with a combination of bonds and stocks in proportion to your risk tolerance, which for some is determined by their age. I prefer the reward/risk ratio and only buy bonds when interest rates is expected to fall which usually occurs after the first six months of a market plunge. The government has to stimulate the economy by lowering the interest rates in almost all recessions. When the USD loses the reserve currency status, most stocks and bonds would be losers.
Repeating the important prediction, as of 4/2013, the
long-term bond crash seemed to be coming. When the economy improves, the interest
rates will rise. The interest rates is so low now that it has no way to go but up.
It will affect adversely the bonds you’re holding especially the ones with low
interest rates and long maturity from today forward.
·
The government bond
prices could collapse when its issuing country is printing too much money and
depreciating its currency.
A bond at 20% yield may not be good if the company/country has more than 25% chance to default on their bonds.
A bond at 20% yield may not be good if the company/country has more than 25% chance to default on their bonds.
·
Those holding the GM
bonds before the reorganization (i.e. the first bankruptcy) lost more than 40% of
the bond values. Corporate junk bonds (i.e. high yield bonds) have their risk.
Buy a bond fund or ETF on corporate bonds.
·
I believe the muni
bonds are risky. I do not really care about the small tax advantages. Many may
default. If you still want to buy them, buy a bond fund to spread out the risk
instead of buying individual muni bonds. Detroit bankruptcy is a good example
of this. This article was published far earlier than the collapse of several
towns in California and now Detroit.
·
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 rates move 5% up, then the long-term
bond price would move 25% down. It is very rough estimate as it also depends on
how long until the bond matures.
·
Few hold the bond and
see when it matures. If you need a steady income, buy government bonds at an
acceptable rate (for example, greater than 8%). 2012 was not a good year to buy
bonds with low interest rates. Some bonds did default and the owner lost most
or even the entire investment. The GM bonds before its first bankruptcy was one
of them however it is quite rare.
·
China has been a big
buyer of our US treasury bonds. China does not want
to kill the goose that lays the golden eggs. They need a good economy in the USA
in order to sell their stuff, which would create jobs for its citizens.
Afterthoughts
·
This article was
originally written in 2012. If you followed the advice about not buying
long-term bond, you would have saved a lot of money. The traditional allocating
between bonds and stocks was wrong. The decision of buying long-term bonds
should be based on the current interest rates and the market direction.
·
Bond ETFs: TLT (20+
years Treasury Bond).
·
To respond to my
‘Edu-mercial’ (my new term) in 5/29/13, JTS said, “Very educational. Thanks! I'll be out of my bond funds by
the end of the day.”
·
Using rising interest rates as
an example, the long-term Treasury bonds with lower interest rates may not fare
that well rather than the newly-issue, long-term Treasury bonds with a higher
rate.
·
Many financial
advisors are trained to sell bonds. Many split the investment into stocks and
bonds according to the client’s age. It
makes sense to them and their clients. It does not make sense to me especially
on long-term bonds which are interest sensitive.
Bonds do not have a better
record of gains rather than stocks. As in my chapter on the Market Cycle, I
advise my readers to buy long-term bonds only when interest rates are high and
/ or the interest rates are going to plunge. Muni bonds I had been advised to
stay away for more than a year ago and now we have Detroit, a major city, going
into bankruptcy.
·
Avani: This
article is mind blowing. I read and enjoyed it. I always find this type of
article as a way to learn and gather knowledge.
·
Buying a bond fund and an individual bond could
be quite different. Bond funds usually buy a large number of bonds maturing in
different time periods. The maturing 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 different maturity periods to lower your 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 rates are high (say 8%). A 3% yield does not beat
inflation (which is about 3%) even without including taxes.
·
Mortgage REIT is similar to a long-term bond.
Click here
for an article.
Links
Bonds:
Fidelity:
Bonds
vs. Bond Funds
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For more of my reasoning, check out the book described next. The Kindle has 850 pages (6*9) for $9.99. It could be the best $10 you ever spend.
The above is an abstract from my book "Complete the Art of Investing" which is available from Amazon.
I challenged to have the best-performed article in Seeking Alpha history, an investing site, for recommending 5 or more stocks in one year after the publish date. The concepts for that article are discussed in this book.
For more of my reasoning, check out the book described next. The Kindle has 850 pages (6*9) for $9.99. It could be the best $10 you ever spend.
The above is an abstract from my book "Complete the Art of Investing" which is available from Amazon.
I challenged to have the best-performed article in Seeking Alpha history, an investing site, for recommending 5 or more stocks in one year after the publish date. The concepts for that article are discussed in this book.
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