Bonds... Damned Bonds!

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Don't forget about those bonds in your portfolio, they are toxic!

Which bonds/bond funds have the most potential risk if/when interest rates rise.

Do you have an exit strategy? You better!

When I was working on a project on bonds in grad school in 1972, I decided to do a study of bond yields. I nearly fell asleep after I got past 1960. From WWII to 1951, the Fed under the direction of Fed Chairman Marriner Eccles pegged the rate on the 10-year treasury at 0.375%. A few firms like C.J. Divine (later bought by Merrill Lynch) prospered by this, buying up bonds below par and then selling them to the Fed. In 1951, President Truman and Congress increased the independence of the Fed, but simultaneously sent a message that the Chairman is not and replaced him (although he remained on the FRB Board for three more years) with William McChesney Martin and the peg was removed under what became known as the Treasury Accord. Rates were choppy, initially surging when the peg was lifted, but remained low until a gradual rise took them to 1960, the first time treasury yields rose above 4%.

I entered the world of banking in 1972 choosing bonds over stocks due to their poor performance that lasted until the 1980s. I had an unusual perspective, being assistant to the head of investments for Western Bancorp (later First Interstate and now part of Wells Fargo (NYSE:WFC)). In 1981, I was hired as an institutional bond salesman for Merrill Lynch and that was when things got really interesting. Among my clients were the big San Francisco banks. We were in the middle of the highest bond yields in U.S. history and a small fortune could be made on money market instruments.

All that began on October 6, 1979 when Fed Chairman Paul Volcker called a rare Saturday meeting of the Fed Board of Governors. Known as the Saturday Night Special (or for traders who had gone home long on Friday, the Saturday Night Massacre), rates soared the following Monday and eventually ended around February 1986 with the 30-year treasury auctioned at just over a 13% yield! Along the way we passed 10% (the DC-10's or Bo Derek's), and it seemed those rates would be with us forever. Even after the Volcker Fed eased, you would be hard-pressed to find anyone who thought inflation would fall below 6%... or even 8%. They were and Bill Gross made his reputation on a bet that the Fed would have to recapitalize the banks, and since the 5-year T-note was the primary bond of the banks, he went 'all in' and the rest is history.

Only in 1920 did treasury yields rise above 4% (5.25% approx.). The point is that between 1942 and 1986 bond yields went from 0.375% to 13% and are now at historic (post Accord) lows with the 10-year note at 1.59% and the long bond at 2.35% (a steal when compared to the negative yields in Europe, and now Japan, with even the 50-year Swiss bond in irrationally negative territory). Rates will swing back, history tells us this, but the U.S. is riding a wave of demand that will end with some catalyst.

I am not saying to buy or not to buy, but I am saying that you had better have an exit strategy as I am sure all those bond gurus telling you to buy have, and it better be a good one as this time the exit door will be narrower than at any time in history. Corrections will go at the speed of light… not exaggerating thanks to today's computers and their algorithms. The following is a guide to which instruments will be hurt the worst. Frankly, I would avoid all spread products in bonds, focusing on 'income producing' stocks such as preferreds and ETFs. Avoid all bond funds, especially those with high fees. Remember the returns you are seeing are not that; due to the high premiums which I will explain, they include a return of principal.

First, and foremost, avoid junk bonds… sorry, high yield… there is not enough yield to offset the credit risk. Period! At the other end of the spectrum are zero coupon bonds and they can be just as toxic or more so with no credit risk but the highest interest rate risk. I think you all understand why junk bonds will be a problem so let's look at the history of zero coupon bonds.

The first zero coupon bond… drum roll please… was not issued by the Treasury but a corporation: J.C. Penney (NYSE:JCP)! It occurred in March 1982 and had an odd 8-year maturity. How do you price that? Regardless of the yield, with no cash flow every dollar you invest is 'stuck' in the bond until maturity or it is sold. No one knew how a bankruptcy court would value those bonds… might they choose to do so at the issuance price of $332 or current value or maturity value of $1,000? But hey, J.C. Penney was solid as the Rock of Gibraltar. Note that the price made them a viable alternative for small investors, prime 'meat' for E.F. Hutton and other syndicate members. As with all zero coupon (interest accrual) bonds, taxes are imputed on the accreted value so they better be in a tax-advantaged or sheltered account… many were not.

Many investors and Wall Street were intrigued, not by a corporate zero, but what about a Treasury zero? Ah, here's the rub. While the income accrues for tax purposes, the government had to book them at full face value! You can see what that would do to the budget (on a 30-year bond with a $1 million face amount at a 10% yield would 'net' just $128,840)… but Wall Street was intrigued by the opportunities. Thus, Salomon Brothers and Merrill Lynch went off to the races trying to design and get approval on zero coupon bonds, but the principal and interest payments would have to be 'stripped' and that was what they were called. However, each firm had an acronym: Merrill was first with TIGRS, followed in a day or so by Salomon with CATS, Lehman created LIONS, and more.

These were highly complex deals as each coupon date had to have its own symbol, plus the corpus, which on a 30-year was further complicated by a 25-year call at par! The 'groundbreaking' was the February 1986 treasury refunding. Following the auction announcement which gave the 30-year bond a 13% yield, highest ever achieved, the two firms swung into action. They had set up trusts to hold the bonds so there were 30 semi-annual coupons and the 'corpus' or principal with the odd 25-year call date. It took educating clients to sell them but thanks to a colleague who was good with his Apple computer, we compared the returns. Only in a rising rate scenario would the 30-year bond outperform, but flat to declining you would always be reinvesting the yield below the yield to maturity. That said, those bonds eventually traded with 50 point premiums ($ Px =150), and there you were virtually guaranteed well below the yield to maturity while the zeroes (Strips), earned the same boring 13% ad infinitum.

A colleague referred me to a non-profit which was selling its headquarters building in Oakland. The CEO wanted to invest it all in 30-year treasuries until the CFO explained that if rates fell they wouldn't get the return he expected. I explained the strips and they put a substantial amount in them ($50 million par value cost just $6,442,000!).

The problem with all the variations, however, was a lack of homogeneity (although CATS traded the best) and eventually Treasury convinced Congress to let them issue zeros directly and accrete the value of the debt. This broadened the market even more, and while the TIGRS, CATS, etc., now traded at a slight discount to Treasury strips, which by then eliminated the 25-year call, simplifying the math, they would eventually be replaced by the Strips, adding another layer of comfort and broadening the market.

American Century Benham produced several 'maturities' (similar to target dates) for them BTTRX was a 2025 maturity while BTTTX was a 2020 maturity. I bought both of these, as I did the TIGRS and sold more on the West Coast than any other salesman. A trust department client had the best quarter, year, 3-year and 5-year returns of any portfolio when I convinced him NOT to buy the 10-year T-note but the 10-year TIGR! (Confession: I sold mine a few years later thinking rates would rise, then bought BTTRX and sold it again when rates plunged... never could get back in again - foolish move!)

Guess what? In virtually every quarter, these funds were either the best or worst performer in their category! That, folks, is volatility! Checking them for this piece, I was shocked to see that they are now selling at premiums 105 and 101, respectively, but there is no market for obvious reasons! In other words, stealthily, negative yields have already reached our shores! This has to be due to shorting. Thus, zero coupons are the most vulnerable to an increase in rates.

Corporates and municipal bonds with 5% coupons especially trade at enormous premiums. This is bad news for bond fund investors. Many (most?) look for the funds with the highest yields… those are CURRENT YIELDS (distribution yield/market value), when rates rise the bonds in the portfolio - some selling at premiums of 120 or higher will plummet while the shorter par bonds with 1% and lower coupons will go negative further adding to losses.

What can we learn from this? Some might say 'every dog has its day' but at some point the markets correct. What worked best in one environment may work worst in another (zeros vs. junk bonds), so one has to know the relative value of each instrument you are dealing with.

How will we know when the apogee has been reached? You won't, but if you set limits and stick with them instead of holding on past what you believe they are worth, you will have a leg up on most traders, let alone investors.

In 45 years of bond experience, I have learned one thing more than any other: in bond land, ceteris paribus does not apply. Still think bonds are boring?

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I own REIT's and other high dividend preferreds but NO bank common. I am also holding a substantial cash position currently 45% (highest I have ever had), with little volatility and still above market returns.