Friday, March 15, 2013

Danger Ahead for Bond Investors ... Not a Safe Long-Term Investment

Bond investors typically seek (1) safety of principal, (2) current income and (3) preservation of purchasing power as an important piece of a well diversified individual investment strategy for the long haul. At least that's long been the approach and remains the conventional wisdom.

But it's an idea that's now the wrong one for long term individual investors. And the reasons are directly related to current yields and likely future inflation. Besides, there's much a better and even 'safer' alternative available in blue chip dividend paying stocks.

Inflation is likely to more than offset the current income component of bonds in the future and the inflation adjusted principal value of the bonds will be considerably reduced by the time the bonds eventually mature.

Thus, bond gurus typically advise individual investors to shorten the maturties of bonds or 'ladder' them, meaning invest in staggered maturity dates so the principal is regularly being reinvested at the then prevailing interest rates. This dual approach of shortening maturities and laddering idea is predicated on a belief that interest rates will be rising over time. Which they will.

And that's the reason why investing in bonds is no longer a good idea. Current low interest rates and likely future inflation will cause bond investors to lose their purchasing power. Accordingly, investing in bonds won't be safe at all.

It's better to replace them with solid blue chip dividend paying stocks. Although there's no 'principal,' the value of good companies wil appreciate over time in inflation adjusted terms as earnings increase. And so will dividends paid on those shares as a result of increased earnings. And in the end, that's the best way to more than offset the effects of inflation and enhance the purchasing power of the money invested.

Hockey great Wayne Gretzky said that the key to being a great hockey player was skating to where the puck would be and not to where it was at any point in time.

That's also good advice about many other things in life, including investing. People who own bonds should skate elsewhere when investing, and people who don't own bonds currently should not buy them. Bonds are not now nor will they at anytime soon be a safe and worthwhile long-term investment.

And here's why. Thirty years ago interest rates were in double digits and it was a great time to invest in long-term bonds. Then as interest rates declined steadily for the past three decades, bond investors happily collected high coupon rates and also recorded substantial capital gains on their long-term holdings. A 2'fer.

But that was then and this is now. Conditions today are precisely the opposite of those that existed thirty years ago. In fact, interest rates are at rock bottom historical lows today compared to the historically high double digit levels of thirty years ago. 

Accordingly, unlike the early 1980s, today there's nothing safe --- nothing at all --- about investing and owning long-term bonds. And as interest rates rise over the next few years, the return on money invested in bonds today will fail to keep pace with inflation, let alone produce a positive return. And not keeping up with inflation is a very poor way to invest one's money for the long run.

So when we take the time to analyze the current risks compared to the potential rewards of investing in bonds today, it's a no brainer. Individual investors should stay away from bonds.

The shocking truth about bond forecasting contains a very solid analysis as to why long-term bonds should be avoided as an investment for the foreseeable future:

"Forget all the bond market forecasts you see today. They will only distract you from focusing on what is essential to making a smart investment decision — risk versus reward analysis.

The reality is nobody knows if the final top for the bond market is now or three years from now. It is a fool's errand to play forecasting games because the future can't be reliably predicted. . . .

In the bond market, we know the risk to reward ratio makes no investment sense over a long-term time horizon (10-30 years) and that's more than enough to make a smart investment decision. Here are the facts:

  • Interest rates peaked in September 1981 and have been falling ever since to reach extreme lows today.
  • 2013 provides the most difficult environment for generating income in 140 years . . . . Since 1871 there has never been a lower yield period in history — not even close. . . .
  • The implication is clear — the upside potential in bonds is extremely limited. This is not opinion or prediction: it is mathematical truth. However, that is only the first half of the reward to risk analysis investors must make.

Unfortunately, the second half of the analysis - risk - is also unfavorable for bond investors because interest rates are at historic lows. Again, it is simple mathematics that cause this situation because a modest rise in rates from today's low levels could cause disproportionately large losses potentially dwarfing any income received in the interim.

For example, a mere 1% rise in interest rates on the Treasury long bond should equate to a roughly 20% price decline wiping out seven years of income at current interest rates. . . .

The critical take-away is to stop (owning bonds). Nobody has any clue when (the bond bubble) will finally burst because the future is unknowable. It could rise for years or free-fall into terminal decline starting today. Neither forecast has any bearing on making a smart investment decision today.

The reason that's true is because the risk versus reward analysis is unequivocally clear. The bond market makes no long-term investment sense."

Summing Up 

Bonds are not even close to being a safe investment today.

Individual investors should be guided accordingly.

Thus, rather than wait until after interest rates go up and then make the move to switch out of bonds, "Gretzky" type investors will get out now.

And they will stay out for years to come.

That's my take.

Thanks. Bob.

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