A Long-Term Bond Strategy for Those Seeking Yield

Includes: IEI, SHY, TLT
by: Jeffrey Dow Jones

The environment today is kind of depressing if you're searching for yield. A lot of people are doing crazy things like chasing junk bonds or shaky currencies, which is fine if you can stomach a lot of volatility. But what if you're just the average guy or sovereign pension plan looking for income that you can count on? What do you do if you're the guy who can tolerate a little bit of risk but also wants to get the best bang for his buck on that risk?

Today we're going to outline a somewhat controversial strategy for that. I'll give you a hint: It involves bonds AND dividend stocks. Think of this as a companion article to our Trade of the Decade post of August, where we discussed not just our favorite trade for the next 10 years, but also those of others such as John Mauldin and Barry Ritholtz. It's fine if you don't want to listen to us, but guys like those two have earned the right to be taken seriously.

Right now investors in search of yield are leaning heavily on the bond market, even with the paltry yields on U.S. Treasuries. Before we get to the meat of our strategy, we need to begin with a brief discussion of a really important concept from the bond market that very few people are paying attention to.

The cruel math of the bond market

Bond math gets a little wonky, but I'm going to keep it simple.

Let's say you go out and buy a brand new 10-year Treasury bond at auction. It's a new issue, so the coupon rate and yield are the same, which today would be in the neighborhood of 3 percent. You are guaranteed that rate of return for the next 10 years, and you are guaranteed by the government to get every dollar of your principal back. Pretty cool. Yay 3 percent!

But there's more to the story. Let's say that we get some good economic data and things settle down and interest rates go back up a little bit. The 10-year bonds that the Treasury now issues pay about 4 percent. That's cool if you're shopping for bonds -- but it's not cool if you already own them. The problem is that your bond now pays less than everybody else's bond: 4% is better than 3%, so the price of your bond goes down.

And in our simple example, the price of your bond goes down about 8 percent. The sparkling fresh bond that you paid $10,000 for is now worth $9,200. Ouch! That might not be a problem if you plan on hanging onto the bond all the way to maturity, but maybe you need to sell it because a good opportunity has come along. Maybe you want to remodel your kitchen. If so, that means you'll take a loss.

That's not a forecast. It's simple mathematics. If you own a bond and interest rates go up, it means the value of your bond goes down. I repeat: That's not a forecast or a casual rule of thumb. It is a law by which every bond must abide.

For the last 30 years interest rates have been steadily going down, so pretty much everybody has forgotten what it's like to worry about what happens to bonds when interest rates trend upward. I'm not one of those people who are shrieking that bonds are in a bubble, but the mindset is in some way similar to real estate in 2005. Back then, nobody thought that home prices could go down because ... well, shoot, it had a been a really long time since that had happened.

(click charts to enlarge)

I don't necessarily think the pattern of the last three decades will reverse and start trending back upwards. But you can see that rates are pretty darn low -- and they can only go so low. Sure, they could fall to 1.5% on the 10-year and flatten out there the way they did in Japan; I'd say that's the outcome with the highest probability.

So there are probably a few more cups of punch still in the bowl. But it's getting late and anyone who's still sober can see that the party is winding down. All the cool people have gone home, or -- if they're super-cool -- they've gone to the emerging market after-party. Olá, Brasil!

Bond investors have had it pretty good since Jimmy Carter was in office, and it's probably time to move along. The risks in the future are much tougher to justify, given today's historically low yields. This is why PIMCO -- the coolest cat on the dance floor and the self-proclaimed "authority on bonds" -- is aggressively expanding into equities -- specifically, emerging market equities.

Depending on your horizon and the type of bond you're buying, bonds can still make a lot of sense. Just about everybody should always have exposure to bonds at all times.

But there are long-term risks present in the bond market that we haven't had to worry about in a long time. There are also some fundamental misperceptions that are floating around. We call government bonds "risk-free" because there's no risk of default: You're guaranteed to get your principal back at the end of the bond's life. But you're not guaranteed to get all your money back a year or two after you buy it.

And then there's the risk of inflation. $10,000 will buy you more stuff today than it will 10 years from now, and if the inflation rate is greater than your bond's yield you're really gonna feel like a loser. Something to think about when you ponder those skimpy yields. Is 4.17% really enough compensation for a 30-year Treasury? Think about everything that's happened in the last three decades.

Anyway, there's a lot going on in the bond space right now that investors are unaware of. Everybody is chasing yield wherever they can find it. Disappointment is likely the only thing in their future.

Japan isn't a perfect template of what lies ahead for the United States. But given the decisions we've made so far and our cultural/political policy of exchanging short-term, acute pain for prolonged suffering, I think Japan is as relevant a bit of economic history for us as any.

Sure, the printing-press-powered inflationary scenario could materialize instead. But that would be even worse for your bonds than the Japan-esque long-term deflationary death spiral.

Here's an idea with a better shot at getting you through either outcome:

How to play it

The trade is long term and there are two parts.

The first part is to stay long bonds. Do that any way you choose. Go buy an ETF like TLT (NYSEARCA:TLT) if you're feeling aggressive, and if you hail from Gary Shilling's deflationary camp, go ahead and follow him into the 30-year bond. If you're more risk-averse, check out something closer to the front end of the yield curve like the 1-3 year Treasury (NYSEARCA:SHY) or the 3-7 year Treasury (NYSEARCA:IEI) if you want a little more yield. You're even fine with PIMCO's own Total Return Fund (MUTF:PTTAX).

Part two happens when (or preferably shortly before) the bond party finally does end. Unlike a college fraternity kegger, it'll be a bit more difficult to identify exactly when the fun stops. There will be no flashing blue and red lights pulling up outside. So keep your eyes peeled abroad and don't stay focused on just the bond market. When we get the next big equity washout -- and don't worry, we will get at least one washout in the next few years -- that'll be time to sell all your bond funds. Then simply load up on high-quality, strong-dividend equities. Stuff like Johnson & Johnson (NYSE:JNJ), Intel (NASDAQ:INTC), AT&T (NYSE:T) or Verizon (NYSE:VZ), Royal Dutch Shell (NYSE:RDS.A), Coca Cola (NYSE:KO), Kraft (KFT), or McDonald's (NYSE:MCD). You know, the usual suspects.

I know that sounds really simple right now. But trust me, this is a much harder trade to execute properly than you might think. It requires zigging today while everyone is zagging, and zagging later on when everybody has decided to zig. Getting long the 30-year Treasury is a very unpopular trade right now, and I guarantee that buying equities during the next correction will be equally unpopular. But aren't the toughest trades usually the best? Isn't there a reason why we need maxims like "buy when there's blood in the streets" to steel our resolve and help us pull the trigger?

So there you go. There's a roadmap for the next decade. There's risk in this strategy, but it's manageable and I believe that the rewards relative to that level of risk are attractive. I think it's a way to keep pace with average annual market returns of 4-6% but without the 50% drawdowns. It's a nice variant on Jeremy Grantham's macro strategy of "hold cash and wait."

Disclosure: Long INTC, long SHY.