Savings, money markets and Treasurys are paying next to nothing. But there is plenty of safe income from corporate bonds, both high-yield and investment-grade, in the 5% to 10%-plus range.
There’s lot of income out there, but you had better manage the bond portion of your portfolio well within the safe operating envelope of a controlled maturity-based strategy. If you don’t, get ready for a very big and a very expensive surprise coming in 2014.
[ad#Google Adsense 336×280-IA]Bonds, all types of bonds, are mechanical and therefore predictable.
When rates go down, as they have been doing for years, bond prices go up and their current yields go down.
Current yield is the interest you really earn based on the cost of a bond.
The problem most bonds and bondholders face in the current artificially low interest-rate environment is that rates have to move up.
Many analysts think it will happen as early as next year.
When they do, prices for all bonds will drop. And depending on the maturity of the bonds, they could drop a lot.
The good news is there is a sweet spot in bonds that uses their predictable market price behavior to earn high income, the 5% to 10%-plus kind I mentioned, and control how much the market prices will fluctuate.
Limiting price fluctuation in your portfolio when rates finally move back to reality is an absolute requirement for making money going forward.
All corporate bonds continue to pay their interest when their market prices drop, no matter how much the price falls. They will return $1,000 in principal at maturity, no matter how much a bond’s price drops.
But humans being humans will sell in a panic when they see their account value dropping. There is virtually no risk to their income or principal, but when the red starts to show up, most people will sell at a loss.
The challenge is to earn income in the 5% to 10% range and do it in such a way that you aren’t scared out of your bonds by fluctuations in your account value.
Maturity-Controlled Bond Investing
Here’s how to set up a controlled-maturity bond portfolio that yields 5% to 10% per year. This strategy will also limit your price fluctuations so you don’t join the next lemming-led rush over the nearest cliff.
And, believe me, in the 30 years I have been in the markets, I have seen a lot of totally unnecessary losses in bonds due to panic selling.
The bonds you can hold in this portfolio must have maturities of seven years or less. This is the sweet spot I mentioned.
Last summer, when the 10-year Treasury rate surged from 1.6% to 3%, an 84% increase, the market prices of the bonds in my maturity-controlled portfolio dropped only about 4% to 5%.
During the same period, Treasurys with maturities of 20 years or greater dropped 17.28% and that’s for a guaranteed bond. Bonds of the same maturity that weren’t guaranteed by the U.S. government (municipals and corporates) dropped even more.
You don’t even want to know how much long-maturity bond funds dropped. They are almost all leveraged and that makes them a whole other animal.
Again, seven years or less is the first component.
The second essential element of this strategy is you must stagger the maturities in this seven-year portfolio so you have at least one bond a year maturing between now and 2020.
Let me repeat. This part of the strategy is essential, too. The maturing bonds will make money available every year to buy into what will certainly be rising rates and the lower prices that have to result.
If you don’t have bonds maturing every year to buy into a falling bond market, you will miss the biggest buying opportunity in bonds since the fall of 2008.
In 2008, bonds dropped so much and so quickly, I was earning total returns of 80% and 90% in just months… real returns, not annualized. And the best part of this strategy, the market price of the bonds we bought in 2008 bounced back to par, $1,000 per bond, in less than six months.
Falling prices, rising rates and cash available to take advantage of it!
Here’s a bond that meets both the maturity and yield requirements to give you a livable return and the price stability that will keep you in your bonds where you will make money.
As Much As 24.76%
Kemet Corp. (NYSE: KEM) manufactures capacitors for everything from airplanes to the cruise control for your car.
It has a 10.2% growth factor for the next five years, sales growth is about 5% a year, and it is expected to increase its earnings from a loss of $0.59 per share in 2013 to a positive $0.30 in 2014.
If you dig into the numbers this may not look like a great stock idea, but its bonds are perfect for our purposes!
Kemet has a B- rated bond (CUSIP: 488360af5) that has a coupon of 10.5%. That means it will pay interest of $105 per year, per bond. It will pay it in two equal payments, in May and November, until it matures on May 1, 2018.
By the way, a B- bond has a 98% success ratio in this market.
Oh, and the coupon can never change! It will pay this coupon to maturity no matter what the market price of the bond does.
The cost is about 99.6, which is bond talk for $996 per bond. The current yield, or the price-adjusted yield, is 10.54% (10.5 / 99.6).
This bond also has a call feature. That means the company can buy it back before maturity on May 1, 2015, at 105.25, or $1,052.50. That will bump our total annual return to 24.76% per year.
Let’s review. This bond:
- will return 10.54% in income.
- has a potential total annual return of as much as 24.76%.
- will mature in 4 1/2 years.
- has a 98% chance of paying all of its interest as promised and $1,000 in principal at maturity.
- and, most importantly, has a maturity so short, that when rates start to move back up, compared to longer maturity bonds of the same quality, you will see virtually no market price fluctuation.
Safe, reliable and predictable income, potential capital gains, a stable market price, fresh money to buy into rising rates and no reason to sell in a panic.
That’s how you will make money in this and the bond market to come.
Bonds are a lot more than Treasurys and savings bonds. In this market you need to look at all your options or get used to earning less than 1%.
— Steve McDonald
Source: Wealthy Retirement