Confused About Rates? Skip The Funds, Buy Individual Bonds

by: John Gerard Lewis

Summary

Interest rates have long been expected to be on an upward trajectory by now.

Persistent low rates are still perplexing income investors.

Bond funds are easy to buy, but they expose an investor to rate risk.

The president announced on April 11 that Fed Chairwoman Janet Yellen is not toast.

Well, that's a profound declaration, if not a ringing endorsement. Still, she had to regard it with some measure of relief, assuming she wants to keep the job for a while. And if she does, then Mr. Trump's companion remark - that he prefers continuation of her longstanding low-interest-rate policy - should comfort her even further.

This all came after rates have paused and then receded following the post-election bond boomlet, and one wonders if the much-anticipated secular rise in rates has now been stalled for who know how long. Should investment assumptions now revert to pre-November assumptions? Or should we just figure that, well, rates will indeed (have to) rise as the Trump economy takes off?

I have a confident and bold answer that question:

I don't know.

And neither, I just as confidently believe, does anyone else, at least not with enough certainty to embark on dauntless secular strategies. Case in point: A day after the president said rather pleasant things about Ms. Yellen, the Wall Street Journal reported that 82% of actively managed U.S. stock funds were beaten by their market indexes over the past 15 years. No wonder that investors are abandoning stock pickers and casting their collective fate to the mindless inertia of index funds.

As I've said before, nobody knows anything for sure. And that's the way it's usually been over the decades, which is fine for long-term investors younger than, say, 55. For them, staying invested in equities will quite likely pay off.

But what's a 55-plus, nearly- or already-retired investor to do with rates still low, a president who likes them low, and a Fed chairwoman who has persistently kept them low?

Buy investment-grade, non-callable, individual, corporate and municipal general-obligation (not revenue) bonds.

No, not bond funds, mind you. Funds expose you to interest-rate risk, meaning that if rates rise then the principal value of your investment will decline. I don't want that to happen to my invested capital and neither should you.

(With one possible exception: If you really, really, really need income on which to live, and that need is greater than the need to leave a larger estate for your heirs, then investing in a portfolio of high-yield and other income funds can make sense. If rates rise, your income will rise in kind, and the kids simply won't get as much when you croak. Better that you don't starve to death.)

But if you want to nearly eliminate rate risk, then buy investment-grade individual bonds and hold them to maturity. Sure, their prices will rise and fall before they mature, so if you find yourself needing cash you might have to sell at a loss, as would be the case with a fund. But if you can afford to hold them to maturity, you'll get all your principal back in the end (barring default caused by a change in the issuer's ability to repay).

Inside an IRA, I recommend buying corporate or taxable municipal bonds that mature before you turn 70-1/2. (Yes, some munis are federally and state taxable, and they therefore have higher yields than non-taxable municipal bonds.) If your maturities are any longer than that, you may have to sell them at a loss in order to meet your required minimum distribution amounts.

In your non-tax deferred accounts, buy tax-free munis or corporates.

Simply build a ladder of maturities and reinvest the proceeds as the bonds mature. This will automatically adjust your portfolio to whatever interest rate trend is occurring over any given time. It's like dollar-cost-averaging, only with rates instead of dollars.

Two cautions:

• For the long end of your maturities, be especially careful about quality. I've seen BBB-rated issues fall to B or even CCC+ in a span of two or three years. Just imagine how much bad stuff can happen over a decade or two.

• Make sure you're not buying zero-coupon bonds, which don't pay interest until they mature. They're especially nasty if bought outside of a tax-deferred account, because you'll have to pay tax on the unpaid interest every year. Yuck.

Here are a few investment-grade bonds that I've recently added to the long end of my personal bond ladder. For me, the long end is capped at 10 years out. And I know I said to buy non-callables, but it's OK to buy callables if the yield-to-call is close to the yield-to-maturity - you're getting nearly the same return, even if it's called:

• Reading, Pa., School District, 5% due 2/1/27, Cusip 755638XT5, S&P AA, Tax-Equivalent Yield to Call (2/1/25): 4.44%.

• Louisiana Land & Exploration, 7.65% due 12/1/23, Cusip 546268AG8, S&P A-, Yield to Maturity: 3.417%.

• State of Connecticut 5% general obligation bonds, due 6/15/26, Cusip 20772JC91, S&P AA-, Tax-Equivalent Yield to Call (6/15/25): 4.826%

• AT&T 3.8% due 3/1/24, Cusip 00206RDP4, S&P BBB+, Yield to Call (1/1/24): 3.502%.

• CNA Financial 7.25% due 11/15/23, Cusip 126117AE0, S&P BBB, Yield to Maturity: 4.084%.

(Bond yields and ratings were effective on the date purchased, all within the past four months.)

Disclosure: I am/we are long ALL OF THE BONDS MENTIONED IN THE ARTICLE.

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: Disclosure: I own all of the bonds mentioned in the article.