Yes, I know that bond holders have been among the precious few investors to have enjoyed positive returns over the past ten years. Yes, I know that equity guys usually favor equities. I begin with these two disclaimers because of the intense criticism readers send in whenever I caution against buying bonds.
Warm up your keyboards, I’m warning you again.
In 1999, the cover of The Economist read Drowning In Oil. Oil was around $11. The Economist predicted it was on its way to $5 per barrel. Investors who held shares in Chevron, Texaco, Mobil, Exxon, or the like were despondent over those lack-luster poor-performing positions. Inevitably, I suppose, investors in energy stocks slowly exited their positions over time as capitulation set in. “Let’s get rid of that Chevron; I’m sick of looking at it each month,” I was told. Yes, they felt better.
The dejected holders of energy shares knew what they wanted instead: tech stocks and dot-coms. All of the market’s action was being driven by the new paradigm internet stocks. Prices were rising at a head-spinning pace, and everyone wanted in. The monthly opening of brokerage statements was a heady, self-congratulatory moment. The numbers just kept going up, and they were going up big. Corks were popping, and, the NASDAQ was on its way to its all-time peak above 5,100 in March of 2000. (Check out the NASDAQ now)
Investors ALWAYS want to buy whatever has been working best and sell whatever hasn’t.
For the past two years, money has been leaving stocks and stock funds and going into bonds and bond funds. Yes, they feel better.
Let’s look at the numbers on bonds.
The current 10 -yr US Treasury Note that is yielding 2.625% and matures on 8/15/20 is selling at $100. If rates instantaneously increase by 2 percentage points to a 4.625% yield, the price would fall to $84.22. If rates were to somehow rise 3 percentage points, the price would drop to $77.40. If we consider holding the same note for two years and collect our 2.625% coupon, the price at that time, should rates jump 2 points to 4. 625%, would be $86.85. The point is that investors should be aware that capital losses on bond positions are very possible.
"Bond investors who expect great things from buying 10- year, taxable bonds have me stumped."
What if rates go down 2 percentage points?
The yield on the 10 yr US Treasury Note would be 0.625% (do you really think that will happen?), and the price would jump to $119.23. When considering any investment, the potential risk and reward must be weighed. After assessing risk and reward, investors need to consider the likelihood of both their best and worst-possible scenarios.
US Treasuries are subject to federal income tax, so the real, after-tax yields will be less. Bond investors who expect great things from buying 10- year, taxable bonds have me stumped. Stocks, on the other hand, are yielding as much as or more than Treasury bonds, in many cases. The current tax rate on stock dividends at 15% is lower than the regular-income tax rate on bond interest. In addition, stock investors are much more likely to participate in a long-term economic expansion once we get through our current economic problems. Bond investors, on the other hand, are likely to suffer capital losses as interest rates rise in the event of economic recovery.
There are some opportunities in today’s markets for income investors, but they must be researched very carefully. High- yielding corporate bonds must be examined with as much care as any equity investment. We have been buying some very select municipal bonds for clients with decent yields but only after performing our disciplined research on the underlying credits.
There is a great sense of impatience and frustration with today’s markets, and there is a desire to take decisive action. Please be careful. When the ground beneath you is shifting, it often makes most sense to stand very still until things firm a bit.
Michael K. Farr is President and majority owner of investment management firm Farr, Miller & Washington, LLC in Washington, D.C. Mr. Farr is a Contributor for CNBC television, and he is quoted regularly in the Wall Street Journal, Businessweek, USA Today, and many other publications. He has been in the investment business for over twenty years.