Bonds Just Got More Dangerous: What You Need to Know

Source: Thinkstock

Source: Thinkstock

Investors are largely familiar with the fact that interest rates are incredibly low. This has driven bond prices ever higher as investors hunt for yield. Bond yields are so low right now that even high yield corporate bonds have an aggregate yield of less than 5 percent.

On the one hand, this has meant that investors have made money on bonds. This hasn’t been the case so much in coupons, but rather in capital gains: bonds have become excellent trading vehicles. If you look at the performance of various bond funds, you’ll find that they have virtually all generated meaningful gains:

  1. The iShares IBoxx Investible Grade Bond ETF (NYSEARCA:LQD) has risen 20 percent in the past 5 years not including payouts.
  2. The SPDR Barclays Capital High Yield Bond ETF (NYSEARCA:JNK) has returned 17 percent in the past 5 years not including payouts.
  3. The iShares Barclays 20+ Year Treasury Bond ETF (NYSEARCA:TLT) has returned 25 percent in the past 5 years not including payouts.

The list goes on, but the point is made: assets that investors typically buy for income have become vehicles for generating capital gains.

On the other hand, this means that bonds are extremely expensive. For instance, 10-Year Treasury Bonds have historically yielded more than 5 percent, but now they yield just 2.6 percent. High yield bonds have historically yielded 8 percent – 12 percent or more, but now they yield 5 percent. But while investors know this, they are taking the stance that “the trend is your friend,” which may keep prices moving higher in the near-term. But long term bond prices have to fall: everybody knows this, even the Federal Reserve.

A mass exit out of bonds can create unimaginable chaos in global markets. Most of the world’s wealth is stored in bonds of various sorts, and if bond prices decline meaningfully, then this will have a tremendous impact on the banking system (banks are effectively leveraged bond funds), the insurance system (insurance companies are also effectively leveraged bond funds), and government programs, which are funded in large part by debt issuance. This is why the Federal Reserve is considering imposing an exit fee on bond funds.

The very fact that this is even being considered should be alarming to investors, who need to seriously consider their asset allocation strategies. This means that the Fed is concerned that the bond market can crash, and therefore, it needs a safeguard in place. It also means that the Fed possibly has some catalyst in mind that can trigger such a bond market collapse, and I think investors need to be worried.

In general, I think investors need to be very cautious in bonds, bond funds, and in the stocks of companies that deal heavily in bonds such as banks and insurance companies. While these assets may have further room to run, they are more appropriately treated as trading vehicles than as long-term investments. This means you need to watch prices carefully and use stop-loss orders in case they begin to decline.

But with this announcement from the Fed, I think it might be time to jump ship. These assets have all had a good run, but the imposition of exit fees just doesn’t portend a potential decline in bond prices — it means that if you own bonds, then the Fed is saying that your hard-earned money will be used to prop up a dying banking system, and it will cost you to get your money back.

So the strategy that seems most appropriate in this situation is to simply sell your bond funds. You can keep holding your shares in banks and insurance companies, particularly some of the higher quality ones that have low leverage and trade at reasonable valuations. But again, you need to use stop orders.

You should also consider acquiring assets that will perform well in the event of a bond market collapse. The best asset to own in such a scenario is gold and shares in select gold mining companies. Gold functions as the ultimate safe haven asset when Treasury Bonds lose their safe-haven status, and in such a scenario, Treasury Bonds will no longer protect investors in a lousy market environment.

Disclosure: Ben Kramer-Miller owns gold coins and shares in select gold mining companies.

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