The most graphic reminder of how bad the bond market can sell off was 1994. I was in my fourth year as a broker and we got hit with eight interest rate increases in one year. Eight!

Every interest rate sensitive investment, leveraged bond funds especially, were crushed.

Many bond funds from this period never recovered. I had the very humiliating duty of informing many investors that the so-called widow and orphan safe funds they had purchased just lost 30 percent and it wasn’t coming back.

But the really big losses in ’94 – and there were lots of them – were due to heavy leveraging. It wasn’t a pretty sight.

Stay on the Straight and Narrow

[ad#Google Adsense 336×280-IA]The sickest part, the big losses were totally avoidable by avoiding leveraged funds. In other words, the rate pigs chasing the highest-yielding funds got slaughtered as they always do.

There are a few principals that govern bond investing, and they’re carved in stone: Stay on the straight and narrow and you can have a very peaceful, profitable investing life. Break them and you will pay a dear price, as many did in 1994.

That’s why it might surprise you that most bond funds are breaking all the rules right now to offer the high returns they must to attract investors; actually they’re really rate pigs, and they’ll pay the price for it, again!

The yields bond funds are claiming right now are just too good to be true and well above what you can get from individual bonds. Any knowledgeable person would question how this is possible, but rate pigs don’t care.

When rates move up – and they will – investors in these funds stand to lose billions before they even know there’s a problem.

Leveraged Portfolios

The most common technique bond fund managers use to earn these sky-high yields is leveraging the portfolio.

This is a technique that’s foreign to the average guy, isn’t fully explained in the materials published by fund companies, and will end up being the ruin of many small investors, most of whom can’t afford to replace the losses.

The underlying bonds in a mutual fund’s portfolio can be the highest quality and even within the safer maturity range I’ve been banging the table about for the last three years…

But if the portfolio is leveraged, you’re exposed to an enormous amount of risk – risk you didn’t see going in and won’t see until your share value has plummeted.

For Instance…

Let’s suppose you own a bond fund that has $1,000,000 in net assets. To leverage it the manager literally goes to a bank and borrows against that amount. Some borrow up to 70 percent and 80 percent of the fund’s value. That’s the only way they can get the high yields they must to attract the uninformed.

The mangers then use this borrowed money to buy more bonds and generate more interest. The manager looks like a genius and the rate pigs are thrilled.

The more reasonable funds only leverage 10 percent to 30 percent of their value, but even these will cost their investors.

This all works just fine until interest rates move up. When they do, the cost of all that money they borrowed starts to cost the fund more and more money in interest costs. It comes out of the cash flow, which is the interest from the bonds. If the money is going to increasing interest costs, it can’t go to shareholders.

In some cases, the new higher interest costs can exceed the coupons on some of the bonds in the portfolio…

Strike one!

Oh, and the double whammy, just when interest costs are starting to move up, the value of the bonds in the portfolio is dropping. The share price begins to plummet…

Strike two!

Mutual fund share prices and NAVs are calculated after the trading day closes, not during the trading day as stock and bond prices are. By the time you figure out this is happening, it’s too late…

Strike three!

…Throw the more obvious and avoidable factors like long average maturities – which also give higher yields and greater risk – and premium costs on closed-end funds, and you have a real nightmare on your hands.

Don’t Follow the Herd

Take 10 minutes right now; call your broker or mutual fund company and find out how much your bond fund is leveraged. If it’s in excess of 10 percent, you should think about getting out.

The herd is pouring money into any fund that pays ridiculous yields and the premiums are through the roof. If you have held your funds for any length of time, you should be able to show a profit on the sale.

To invest safely in bonds right now you should own individual bonds – municipal or corporate – not Treasuries. This will give you the control necessary to avoid the damage of long maturities and leveraging, and the premium issue can be completely avoided.

One Bond Within the Rules

Here’s an example of a bond that you can own that’s within all the hard and fast rules about bond investing.

  • International Lease – cusip 45974vb49 – the annual yield is around 7.19 percent, the price is 96.5, or $965, and it’s rated BBB – and matures on 6/1/14.

It has about a 2.5-year maturity, which keeps you in a very short-term hold and out of longer maturities, which also get killed when rates move up.

You’re also buying it at a slight discount of $965. At maturity you get par or $1,000. Not bad!

Oh, and it’s an investment grade bond! That’s always a nice cushion.

You get return well above market averages, an investment grade rating, no leveraging unless you borrowed the money to buy it, a super-short maturity and a slight discount, $965 versus a premium or par bond, which helps your annual average return.

That’s how you invest in bonds safely and profitably.

Can you get more from highly leveraged bond funds with maturities out to 20 years?

Yes, and you’ll get crushed for your effort.

Bonds can offer you security and return if you don’t act like a rate pig and obey the few basic principles that are carved in stone. Do this and you can have a very nice investment life with bonds.

You can thank me later.

Good Investing,

Steve McDonald

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Source: Investment U