Barbells, Ladders and Avoiding Bondage
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When your whole world is falling apart, there are always government bonds. Not that the world is falling apart. But neither does it seem to be holding together very well.
Today it’s tattered. Tomorrow maybe it falls apart.
We really haven’t seen anything yet. Stocks are 10-15 percent off their highs. That’s all. And many sectors have been holding up quite well, like energy, agriculture, rails, and commodities.
But moving forward, we can’t have everything go our way. For example, if inflation is to slow down, energy, food, and commodity prices will have to start getting lower. But that means most of the few remaining robust sectors will begin fading along with the greater economy. And the stock market will have lost its last leaders.
And if they don’t? Then we’re stuck with inflation and slow economic growth otherwise known as the dreaded stagflation.
Choose your poison: Continued high prices or equities that will be pushed much lower than where they are right now. In other words, stagflation or a worsening bear market.
As my charming colleague Lynn Carpenter pointed out in last week’s article, even the safe haven of dividend stocks isn’t a slam dunk anymore. You have to look before you invest, especially among financials.
If you’re thinking safety first – and returns a distant second – there’s really only one place to go.
U.S. Government Bonds may be boring. They may give underwhelming returns. But at least they’re safe. And they do have the full backing of the U.S. Government. And that still means something. Even my esteemed colleague, Rusty McDougal, would have to concede that point.
The biggest challenge in buying bonds? Locking in at an attractive interest rate. When you buy a government bond, you’re loaning the government money. The longer the government keeps your money, the higher the interest rate it needs to offer you.
If you were negotiating, you’d say something like, “If you want my money for two years, you’ll need to pay me 1.8 percent interest. But if you want it for 10 years, you’ll have to pay me 3.5 percent interest.
This is what actually happens, except the government gets the message not from words but from the actions of millions of people buying and selling government bonds every day.
The risk you’re taking with these government bonds isn’t that they’ll go bad. It’s that inflation will eat away at your earnings. If you’re making 3.5 percent interest on a bond investment, but inflation is going up at the rate of 4 percent, for all practical purposes you’re losing money.
That’s not a good way to save, is it?
Consumer prices are climbing at a 4.1 percent clip right now. But if investors believe these numbers badly underestimate the true rate of inflation, as I do, then they should begin to do more selling than buying of bonds.
This is the self-regulating mechanism of the market. As investors sell, the price of bonds goes down – just as selling pressure pushes the price of stocks down.
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And as bond prices go down, their yields go up. As yields rise and become more attractive, it once again draws buyers into the bond market.
“Bond interest rates (not the original yield but the “yield to maturity”) are constantly moving up and down in response to this buying and selling. When you buy a bond, it’s hard to be sure whether the interest rate you’re getting will be better or worse than next year or the year after. Once you buy the bond, your interest on that bond (the original yield) is locked at that rate.
However, the price of your bond will fluctuate – as rates move up and down.” And if you’re not sure, then you should not put all your eggs in one basket.
Diversifying your bond portfolio is just as important as diversifying your stock portfolio. But instead of diversifying by sector, you diversify by time.
There are two good ways to do this. You could ladder your bonds. Or you could barbell them. Let’s look at laddering first. Building a bond ladder is easy. The objective is to be in a position to reinvest your bond returns every couple of years.
Let’s say you have $50,000. Through your broker you could buy a series of 10-year notes. The first series mature in 2009. You buy $10,000 worth. The second series mature in 2011. You put down another $10,000. The third matures in 2013, the fourth in 2015, and the fifth in 2017. You put $10,000 in each.
And what do you do with the money you get when you redeem the note maturing in 2009? You invest it in a bond maturing in 2019. And so on.
That means when interest rates are going up, you’re in a position to buy. When they’re going down, you’re also buying. For some people, that sounds very safe. For others, it may sound a little crazy…
Why invest in bonds maturing in 2019 if you’re getting a less attractive rate than, say, for 2017? Why not wait? But rates for bonds maturing in 2020, or 2022, or 2025 could continue to head down. You may be waiting a long time for nothing.
And if they reverse and head up? Well, you’ll be in a position to capture those higher rates as you move up the ladder (in years). Then in 2011 you could reinvest the money from your maturing bonds into bonds that are maturing in 2021. And so on.
Laddering is a very safe way to spread the interest rate risk you get with bonds. And, by now, you should know my position on this. I’d rather have you laddering with Australian bonds – or other overseas bonds with attractive rates denominated in strong currencies – than U.S. bonds.
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Tags: bear market, Commodity Prices, Dividend Stocks, energy, Food Prices, Government Bonds, inflation, interest rates, stagflation, U S Government Bonds, Us Stock MarketAbout the Author
Andrew is currently the Editor-in-Chief of two monthly investment research services INCOME and The Wealth Advantage. He has also become a leading expert in utilizing Exchange Traded Funds to profit from rising and falling market sectors.
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