Secrets to Successful Bond Investing

The rules to bond investing:

  • Use an Institutional class (“I” class) open-end no-load mutual fund
  • Shop for quality: get low risk (high credit quality) rather than high yield
  • Buy only mutual funds that hold investment grade bonds
  • Avoid mutual funds that try to dilute their holding of investment grade bonds with junk bonds, examine what percentage of each credit grade is in the bond fund
  • Don’t use closed-end mutual funds
  • Don’t use passive index funds – get actively managed funds
  • Avoid most bond ETF’s except for very large, seasoned ones holding only Treasuries
  • Don’t buy individual bonds – the Broker markup/markdown is a terrible hidden cost unless you are truly wealthy

Understanding bonds

When interest rates go up then bond prices go down

When inflation increases then interest rates go up, thus hurting bond prices

It is not cost effective for retail investors to buy individual bonds, they should use mutual funds

Less is more: the high yield junk bond asset class has produced a lower total return than the asset class of lower yielding quality bonds (because of bankruptcies by junk bond issuers)

If the dollar goes down that could cause inflation, which damages bonds. However, most countries want to have competitive devaluations so it is difficult for our government to make the dollar go down. Further, only 17% of goods are imported, so a devaluation of 20% would create one-time extra amount of inflation of 3.4% on top of the usual 1.5% inflation.

Understanding Treasury default

If the government is close to defaulting and covers up the problem by stalling for a few more years then the marketplace will anticipate a future default and gradually begin to sell off their Treasuries. The current budget agreement signed 8-2-2011 did not really fix or change anything! It increases the chance that on 12-31-2012 the same problem will occur again to be settled by the winners of the 2012 election. So during the month of January, 2013 Congress and the president will debate and the Treasury will operate with inadequate funds, procrastinating on paying its expenses for a few weeks until the next dispute is settled in February, 2013.

Probably a recession will occur in 2012 and there will be a flight to safety benefitting Treasuries in 2012 and 2013 so probably Treasuries will not experience a risk premium increase in rates in 2012 and 2013. The inflationary blow-up of Treasuries could be many years from now. In the Great Inflation of 1965-1982 it was not until 14 years after 1965 when rates went to extreme levels, except for a brief time in 1972.

The risk of Treasury default is a misunderstanding because the government owns the world’s best printing press and the debt is payable in our own currency. The U.S. has more natural resources such as gold bullion, coal, oil, natural gas, metals, farmland than the rest of the developed world combined.

 

About the author

Don Martin, CFP®

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