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The biggest risk for most investors is one they are not even thinking about: Bond funds, the black swan of 2012.

Individual investors are on a mission. The cry comes from everywhere: Give me yield!

Scared witless by the housing bubble, the stock market decline in 2008, and the continuing headlines, the average investor makes the mistakes that come so naturally:

  1. Chasing past performance -- bond funds have done well.
  2. Confusing true yield with current payouts -- many "yield plays" are simply returning your capital.
  3. Failing to balance risk and reward -- yield history provides a false sense of security.

These combine to create a false sense of security about investments in bond funds. Many investors, despite the warnings in the prospectus, think that these are safe investments with assured yield.

Not so!

The Risk in Bond Prices

Whenever you buy a bond, the price is determined by current yield. If interest rates move higher, the bond price must go lower to generate the new market yield.

Anyone who does not understand this relationship should not own a bond fund. You can get badly burned. One of my best friends owned bonds on the 70's when rates spiked. He lost a fortune and explained that he would never buy bonds again. (This was before my investment advisor days.) We can all see that it was the wrong lesson. Bonds were a great investment just at the moment he was selling! It is pretty much the opposite of the current market.

How to Think About Bonds

To start the process here are three questions:

  1. What do you expect the inflation rate to be over the next ten years? How about next year?
  2. If inflation increases, what do you think will happen to interest rates?
  3. Do you need any of your funds within ten years?

Let us suppose that you want to be super-safe, so you have joined the crowd in buying the (formerly AAA-rated) US Treasuries. Let us take the benchmark 10-year note as our example. If the interest rate moves from the current 1.61% to 2% you will have an immediate capital loss of about 3.5%. If the rate moves to 2.5%, your loss is about 7.8%.

And we are just getting started.

You will not have capital losses if you do not sell the bonds, but what if you are in a bond fund?

The Rules of Bond Funds

The problem with bond funds is that you cannot control when the selling occurs. If there are redemptions, the fund is forced to sell, even if losses are locked in. Since we have had a multi-year run of inflows to bond funds, no one thinks about the dark side.

You will never hear about this risk from bond fund managers (think Pimco, whose employees all seem to follow the party line) or researchers that work mainly for bond guys (Bianco). These guys have only one product to sell, so you will never hear a valid comparison of stocks and bonds on a risk/reward basis.

Objective Sources

Over the years a number of readers have commented along the lines that people like me are trying to sell stocks. The most aggressive of these have called me a "shill" for the sell side firms. I understand that some of these are paid trolls, and I usually only make one polite response. It is a bit aggravating because it is so wrong.

The truth is that independent investment advisors profit only when their clients do. We are completely aligned, attempting to find the best asset allocation. I start with each new client by asking whether we are attempting to preserve wealth or to create wealth. I manage six different programs including bonds, stocks, ETFs and alternative investments. The right mix differs by client.

I have new clients -- right now -- for whom a major emphasis on bonds is correct, so that is what we do. This is completely unlike the "expert" you see on TV who makes his money exclusively by selling gold, or stocks, or annuities, or bonds.

My Chicago colleague and friend Brian Gilmartin provides similar advice on asset allocation. He covered the topic in fine fashion in this recent article on his new blog. It is a good illustration of how a first-rate manger tries to incorporate bonds for clients.

An Alternative Concept

I have a different approach to bond investing. It is strong, and working well. Here is the mantra:

Buy bonds, not bond funds!

My approach is a bond ladder. See if you qualify.

  • A strong focus on guaranteed return;
  • No immediate need for the principal;
  • Desire to participate as rates move higher;
  • Willingness to accept a modest yield. (If you need more, you should be in our enhanced yield program described in Part 6. It is an individual matter.)

A bond ladder meets these objectives. The exact specifications can vary but my rules are as follows:

  • Five "rungs" with three bonds per rung;
  • Everything is investment grade with no company on negative watch;
  • Only one bond per company;
  • Careful shopping on entry to get the best prices (which affects the yield);
  • Ability to "roll" to higher yields if/when rates move higher.
  • The investor has fifteen different high-grade bonds with very little risk and the ability to ratchet up yield over time.

When we get paid on a maturing bond, we reinvest at the long end. We are not at the mercy of other investors who may not share our interest.

Why is this Special?

Why is it that every investor is not doing this?

It is a bit tricky. Most investors are comfortable buying stocks, but they do not understand how to buy bonds. There are some tricks and traps. It is well worth learning, but it takes a little work. It is a complex subject. I have new clients building current bond ladders, and I'll provide some specific examples in future articles.

Meanwhile, I want to highlight a great educational site about bonds. If you are interested in fixed income, you should set aside some weekend time to explore the many great ideas at LearnBonds.com (now added to our featured sources).

Conclusion

If you own bond funds or bond ETFs you should conduct an immediate review. Taking personal control of your bond allocation requires owning bonds, not bond funds.

Source: The Quest For Yield (Part 7): The Role Of Bonds