Now is Not the Time to Buy Bonds, Maybe

The conventional wisdom says that you should own your age in bonds.  If you are 20, you should have 20% of your investments in bonds.  If you’re sixty, it should be 60%.

The idea is that as people get older they need to get more conservative with their money, gradually shifting from uncertain growth investments to more certain income investments.  An ideal situation when you’re living on your savings is to have your bonds and dividend paying stocks paying enough interest to cover your expenses so you don’t need to sell stocks to raise cash.  Money just magically appears in your accounts as you need it.

The trouble is that we are not living in normal times.  To try to spur the economy, the Federal Reserve lowered interest rates essentially to zero.  When that didn’t work since no one had good enough credit to borrow money and businesses didn’t see any reason to expand with no one buying anything the Federal Reserve started buying buckets full of long-term bonds to bring down long-term rates.

This caused home mortgages to go down to unheard of levels.  No one was interested in buying a house, however, since so many people were upside-down in their mortgages.  People who could, however, refinanced their existing mortgages, reducing their payments and freeing up cash.  This has started to help the economy somewhat, but the recovery still isn’t much better than the recession.  Part of the reason is that unemployment benefits are so good that many people choose not to go back to work, meaning there are a lot of people not producing anything or moving up and increasing their income.

The good news for borrowers is that the economy has been so bad that interest rates have stayed low.  This has caused stock prices to go to new highs.  Bond prices also increased initially as rates were lowered, but have stayed in a trading range ever since.

Normally one would want to have a  substantial amount of savings in bonds later in life.  The trouble is currently that when rates do go up, either because the Federal Reserve raises rates to temper the economy or because inflation picks up because of all the easy money out there, bond prices will fall.  We could easily see declines of 10-20%, which would wipe out years’ worth of interest for bonds paying 3-5%.  Dividend paying stocks would be hit too unless the economy does start to recover and the underlying businesses start posting good profits.

The trouble is, sitting on the sideline waiting for this bond collapse that will occur eventually may leave an investor in cash waiting for years.  (These kind of things are easy to predict but very difficult to time.)  This could mean sitting in money market funds earning 0% when you could have been earning 3-5% for the next three years.  The internet bubble was similar in that it was obvious stocks were ripe for a fall back in 1997-1998, but the party continued on for a couple of years after that.

So, what to do?  It probably is best to have some bond exposure.  Sure, you’ll be looking at a reduction of 10-25% in price when interest rates rise, but if you hold long enough you’ll regain much of that loss.  Buying shorter term bonds would also be good, as would picking bonds which are below their redemption price (typically 100) per bond).

Spreading out into income investments would also help.  Buying dividend paying stocks would allow income both from dividends and price appreciation.  Stocks are also a good inflation hedge – if held long enough – since the price of the property of the company will increase with inflation and they will be able to pass along price hikes to their customers normally.

Another option is to get into real estate, either by buying rental properties or buying REITs.  These are also a good inflation hedge since the value of the real estate will increase with inflation.  There is some correlation with interest rates since investors will want a better return for their money when interest rates climb and higher rates make it harder for people to afford a loan, but in general bonds and real estate don’t move in lock-step, meaning you real estate portfolio may be up when bonds are down or vice-versa.

A final good source of income are Master Limited Partnerships (MLPs).  These typically own things like oil and gas pipelines and generate lots of cash.  Energy prices will also climb with inflation, making them a good inflation hedge.  The downside si that the tax treatment can be very confusing, even in an IRA.  It is well worth an hour with a CPA before buying into these to make sure you won’t be filing a dozen state income tax returns.

Disclaimer: This blog is not meant to give financial planning advice, it gives information on a specific investment strategy and picking stocks. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

Comments appreciated! What are your thoughts? Questions?

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