Spokane Journal of Business

Now might be a good time to sell off bonds, bond funds

Many investors now are too heavily weighted toward the steady asset

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Right now may be the best opportunity to sell bonds or bond funds.

Look at the flows of invested dollars into mutual funds during the past few years as described by the Investment Company Institute. Investors allocated more than $360 billion to them in 2009, $230 billion in 2010, and just over $120 billion last year. It continues in that fashion this year. As of late last month, investors had pulled another $126 million out of stock-based mutual funds and shoveled yet another $10.7 billion into the bond funds.

In comparison, they've pulled significant money out of stock funds in each of the past five years. So, I think it's pretty clear that investors have bond-heavy portfolios.

Historically, individual investors have been hesitant to sell this asset class with its perceived safety and predictability—the operative term here is perceived. Investors need to understand that bonds behave like stocks, gold, or any other investment. And when an asset class has gone up in price to the great extent that this one has—almost a straight line over 30 years—it's perfectly fine to take profits, especially when there's no more room for it to grow.

Why do I say this? In 1981, you could receive a return of 15.77 percent by investing in a certificate of deposit for six months. That's not a typo. A recent reading of available rates in our area for a six-month CD would provide you a return of 0.15 percent.

In my estimation, this simple example is the best way to illustrate the bull market in bonds during the last 30 years. As I like to say about bonds, it's just math. As interest rates dropped, the prices of existing bonds tended to rise. People who had been investing in bonds and bond funds throughout this period generally saw their asset values rise and incomes remain steady and predictable.

However, with rates about as low as they've ever been, and being held down not by market forces but through monetary policy manipulation, it's inevitable that the rates have to turn higher as the economy continues to recover and the demand for money increases. The cycle may have turned already as the low for 10-year U.S. treasuries was 1.72 percent, set back in September.

Dr. Jeremy Siegel, finance professor at the Wharton School at the University of Pennsylvania, captured the situation nicely when he said, "The rally in bonds was a once-in-a-millennium event, but it's absolutely mathematically impossible for bonds to get any kind of returns like this going forward If you missed the rally in bonds, well then, that's it."

I believe that the bond market is already in a bubble situation. During the past couple of years, in order to maintain their income, many investors have had to move into bonds or bond funds with long-term—greater than 10 years—maturity dates. Those investors are now at the greatest risk of principal loss because the idea that these artificially low rates can last for some time just makes no sense whatever.

The simplest way to think of the risk is that as interest rates rise, the value of existing bonds—regardless of quality—drops. The further in time until a bond comes due, the greater the risk. Income will continue, but if you wanted to trade into another bond with the market rate, you'd sell at a loss.

Here's the problem. CDs and bonds do a fine job of one thing. They pay a set sum of money during a defined period of time. When that period is over, you get your money back. That's great, so far as it goes. For short-term needs and emergency funds, they're fine. The downside is that these instruments offer zero protection against inflation, what I like to call "the hidden tax." This tax won't show up on any statements, but it will erode your ability to maintain your buying power in the future.

The Census Bureau folks tell us that a 65-year-old woman now has a 50 percent chance of living past age 86. A 65-year-old man has the same odds to live past age 84. Assuming that annual inflation averages the 3 percent that it has during the past 80 years, this means that the cost-of-living for those people shall just about double by those ages.

If not bonds, then what? There are a number of options available that, properly allocated, can provide a steady income that can rise with inflation, and provide some protection against inflation and appreciation of assets.

For clarification, I'm not suggesting you totally bail on bonds.

Generally, it would be wise to reduce combined bond-and-bond fund allocation to at least 30 percent or 35 percent now, before rates start to really move higher. And this is regardless of age. That old wheeze about having the majority of your long-term or retirement assets in fixed-income investments was great when life expectancies were much lower. Not now.

As to the types of bonds you should have in that allocation, there should be nothing with more than a 10-year maturity. Stick with high-quality—A-rated or better—bonds. Also, senior floating-rate funds, such as that offered by Oppenheimer (OOSAX), will give you a portfolio of issues with rates rising with the prevailing interest rates. Because the rates rise, this tends to minimize the share-price fluctuation that traditional bond funds suffer.

Another choice is quality dividend-paying stocks, or as some have recently tagged them, "growth bonds."

There are also real estate investment trusts, commonly referred to as REITS, pronounced reets. These can provide income and diversification from all types of real estate assets throughout the U.S. For example, in health care, there is HCP. A mixed portfolio of properties can be had through Washington Real Estate Trust (WRE). The Simon Property Group (SPG) is a shopping center owner. There's even storage units through Public Storage (PSA). And because they're real estate, you have the inflation hedge possibility as well.

A tax-advantaged way to provide current income, an inflation hedge, and upside potential is to put together a portfolio of master limited partnerships. These trade on the exchanges and must pass most of their cash flow through to their unitholders.

In my experience, most individual investors wait too long to get out of a position and wind up selling at lower prices as the herd is all trying to close out at the same time.

Peeling back your bond positions now and transferring the assets into similar issues is a smart way to play defense.

Put another way, don't wait until this bond bull has become a line item on the McDonald's value meal menu before reallocating your holdings.

  • Michael Maehl

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