Bonds have long been sought after for their stability and safety. For those following a disciplined asset allocation model, bonds likely make up a significant portion of their portfolio. Over time, this has been a well-devised plan. However, to continue holding significant positions in bonds in this economic environment will likely result in a catastrophic end.
In a recent Bloomberg article, Warren Buffett described bonds as “dangerous” and said that they "should come with a warning label." What makes bonds so dangerous now is how they work and their relationship with interest rates. Here is what you need to know and what you can do to protect yourself.
How Bonds Work
A bond is a debt security in which the issuer agrees to repay borrowed money with interest at fixed intervals. Bondholders have a creditor stake in the company. Technically, bonds do not pay dividends, but instead they pay interest.
Interest rates play an integral part in determining the current value of a bond. Interest rates and the price of a bond are inversely related. The longer until a bond matures, the more susceptible its price is to changes in interest rates.
Consider two bonds, one that has a maturity of 30 years and another with a 7 day maturity. If, after both bonds are sold, interest rates go up one percent, the price of both bonds will decline since new investors expect to earn the prevailing interest rate. However, the interest rate decline will affect the price of the 30 year bond more than the 7 day bond, due to the longer period of "lost" earnings. It works the same in the other direction - if interest rates drop the bond holder will sell it at higher price which lowers the yield to the market rate.
Where Will Interest Rates Go From Here?
With short-term bond interest rates hovering around 0%, it's not difficult to determine the direction of the next major move. Although the Fed has stated it will keep rates low for the next couple of years, have you considered how rates are being held at such low levels?
When the U.S. government issues debt and there there is not enough demand at the price point needed to keep the rates low, the Fed steps in and purchases the excess debt at the appropriate level. In purchasing this debt, the Fed is creating yet another problem.
The Fed has no source of income that will allow it to make the debt purchases in the needed magnitude. One thing the Fed can do that no one else can is to control the U.S. money supply. The Fed distributes new currency for the U.S. Treasury Department, which prints it, and the printing presses have been quite busy. Eventually this will lead to higher inflation and in times of inflation, those holding debt are the losers.
Protect Yourself With Dividend Stocks
Late last year I started reducing my exposure to bonds, I plan to continue moving in that direction during 2012. I will be replacing the debt with quality blue-chip dividend stocks that are yielding in excess of my bond holdings. Consider these dividend stocks that have a current yield in excess of 2.8% (the 20 year Treasury rate):
(NASDAQ:ADP) is one of the world's largest independent computing services companies, providing a broad range of data processing services. Yield: 2.9%
(NYSE:CVX) is a global integrated oil company (formerly ChevronTexaco) with interests in exploration, production, refining and marketing, and petrochemicals. Yield: 3.0%
(NYSE:EMR) designs and supplies product technology, and delivers engineering services and solutions to a wide range of industrial, commercial, and consumer markets around the world. Yield: 3.1%
General Mills, Inc.
(NYSE:GIS) is a major producer of packaged consumer food products, including Big G cereals and Betty Crocker desserts/baking mixes. Yield: 3.2%
(NYSE:PEP) is a major international producer of branded beverage and snack food products. Yield: 3.3%
The Procter & Gamble Company
(NYSE:PG) is a leading consumer products company the markets household and personal care products in more than 180 countries. Yield: 3.2%
(NYSE:ABT) is a diversified life science company that is a leading maker of drugs, nutritional products, diabetes monitoring devices, and diagnostics. In mid-October 2011, Abbott announced plans to split the company. Yield: 3.4%
Johnson & Johnson
(NYSE:JNJ) is a leader in the pharmaceutical, medical device and consumer products industries. Yield: 3.5%
(NYSE:SO) is an Atlanta-based energy holding company that is one of the largest producers of electricity in the U.S. Yield: 4.3%
In my opinion, the Treasury has already printed enough money to cause significant problems in the future. The questions are how big will the problems turn out to be and how long will it take us to recover? Let me be clear, I am not predicting the imminent collapse of bonds. As an investor (not a trader), I am not in the prediction business. However, I believe we have reached a point where there is much more to lose than gain by holding bonds.
Full Disclosure: Long ADP, CVX, EMR PEP PG ABT JNJ in my Dividend Growth Portfolio and long SO in my High-Yield Portfolio. See a list of all my dividend growth holdings here.