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Message: How the Stimulus Will Drive Bond Profits To New Highs
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How the Stimulus Will Drive Bond Profits
To New Highs By Steve McDonald
A simple corporate bond strategy can make you a ton of money in the next few years, with almost no risk to your principal. And it's so simple it's almost unbelievable.
As the stimulus and banking packages unfold, there is one thing that we know for certain, there will be one hell of a lot of money printed and pumped into the system. The success, or degree of success of these programs is still up in the air, but we know for certain that we will have a lot of new money out there. These bailouts will result in a series of events that will make corporate bonds the place to be for a very long time. In fact, bonds may be the only place you will make money in the next few years. The first event is already in progress, printing lots of new money to finance the bailouts. Let's ignore the cost of financing these bailouts and just look at the effect it will have on inflation. Unavoidably, inflation will be primed to take off. It's like pouring gasoline on a fire. You pour enough money on the economy and the flames will get bigger. This is the second event. As we all know, too much inflation is death for our economy and the stock market. It's like not being able to get your in-laws to go home. Life is awful. You have to have lived through the late '70s and early '80s to appreciate this fact. Are double-digit interest rates like the early eighties possible? Considering the amount of new money being pumped into the economy, it is more likely than most can imagine right now. The third event, the Fed will have to raise interest rates to control inflation or hopefully stop it before it can do its damage to the economy and the stock market. Look back to 1994 and see what multiple interest rate increases did to the stock market in a normal economic environment. The average stock was down at least 30%. I can't imagine what will happen in the already challenged economic environment we have now. The fourth event will be for bond prices to drop as the Fed increases rates. How the Fed's actions affect bond prices is not a complex relationship, but it would require too much space for me to explain here, so you'll have to take my word for it. These interest rate increases will create one of the best buying opportunities in bond history. Using a simple strategy, you will be in a position to buy up discounted bonds at higher current yields than they were paying last year. Discounted bonds not only pay you a higher current yield than the coupon of a bond, it also pays you capital gains at maturity. In the past six months, I have taken capital gains on these same types of bonds as high as 97% in less than two months.
If you are a person that buys long maturity bonds to get the highest interest rate you can, you may want to pay particular attention to the rest of this article. Long maturity bonds will be crushed in what appears to be all but a guaranteed high interest rate, high inflation environment.
Here is a simple and safe method for beating the market for the next five years. Invest in ultra short term, investment grade corporate bonds on an averaged and staggered basis. Here are the particulars. Investment grade only. Junk bonds have earned their name. Does this mean you can never have a BB bond, investment grade are BBB to AAA, no. There are some exceptions, but staying in investment grade bonds gives you an 80-year documented success ratio of 99%. That means 99% of the time investment grade bonds pay off. Junk bond payouts are significantly lower. No matter what is happening in the economy, quality is always your safest bet in investments. Short term, staggered maturities of three years or less. This is the key to the success of this approach. It will sound very foreign to most bond investors, but give it a chance. Long maturity bond prices are crushed by interest rate increases. Short maturity bonds, in this strategy that means six months to three years, will drop in price but much less. Since they mature sooner they also allow you to buy back into a rising interest rate market and take advantage of the price drops. In long bonds, you're stuck. The ultra short maturities give you as much protection as possible from getting stuck in bonds that you will have to take a loss on to get out of in the coming inflation. There are two more techniques you need to use to add a little more security to this method: staggering and averaging in. Staggering your maturities will give you an extra edge. It's accomplished by buying into the market in small amounts, five or ten bonds at a time and plan on having 10 to 25 different bond positions added to your portfolio over a 12 to 18 month period. This does two things. It averages you into a market over time, which will typically give you a better average cost, and it staggers your maturities so you will have several bonds coming due every year. This gives you fresh money to reinvest as bond yields go up and prices come down with the rate increases. Staggering and averaging in will also give you better diversification, which is always a good thing. No matter what you choose to do, never load up on a few bonds because the coupons look to be good at the time. This is the oldest trap in the money business for conservative investors. It will end up costing you. Don't let your lack of familiarity with bonds keep you from using this technique. Take a look at the Bond Trader, it does everything I have described here and uses a few additional techniques to give its investors the long-term returns of the stock market without stock market risk. To date it has not had a single loss. Keep your eye on the horizon. |
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