Buying bonds is the ultimate contrarian play because everyone knows interest rates are rising, and when rates rise, bond prices fall. The yield on the 1-Year US Treasury increased 1,528% over the past year, while the yield on the 10-Year US Treasury “only” jumped 64%. All rates along the yield curve have increased substantially, and they will probably continue to rise.
In 1990, long-term interest rates reached 9%, and I could not give bonds away since investors were convinced rates were going higher because, in the 1980s, they touched 15%. However, rates declined from 1990 to 2020, falling to a low of .62% – a drop of 93%. The ultimate bull market in bonds occurred from 1982 to 2020.
A 30-year bond will fall 19% if interest rates rise from 2% to 3% – not a compelling argument to buy bonds. And the higher rates go, the lower prices will fall. We sold most of our long-term bond holdings in March 2020 as yields pushed below 1%, and we shortened our maturities to about two to three years and realized gains while transitioning to a defensive position. As interest rates rise, we will extend the maturities of our bond holdings to capture higher yields.
If rates rise, is there a bond strategy that makes sense? I believe there is, and it’s called a bond ladder. A bond ladder works in a rising or falling interest rate environment, and as rates rise, a bond ladder allows you to generate more income.
Here is how it works. You purchase a three-year bond ladder with bonds maturing in one, two, and three years and they pay 1%, 2%, and 3%, respectively.
- Bond 2023 pays 1%
- Bond 2024 pays 2%
- Bond 2025 pays 3%
- Average yield = 2%
When the 2023 bond matures, the remaining bonds are now one-year closer to maturity. You now purchase a new three-year bond maturing in 2026, paying 3% with the proceeds from the 2023 bond. Your new ladder now looks like this:
- Bond 2024 pays 2%
- Bond 2025 pays 3%
- Bond 2026 pays 3%
- Average yield = 2.6%
Your income increased from 2% to 2.6% or 30%.
When the 2024 bond matures, the remaining bonds are now one-year closer to maturity. With the proceeds from the 2024 bond, you buy a 2027 bond, paying 3%. Your new ladder now looks like this:
- Bond 2025 = 3%
- Bond 2026 = 3%
- Bond 2027 = 3%
- Average yield = 3%
Your income increased by 15%.
Your bond ladder can consist of any maturity from one to thirty years, depending on your appetite for risk. Eventually, your ladder will contain higher-yielding long-term bonds with monthly, quarterly, or annual liquidity.
A physical ladder will take you higher with each rung you climb, and a bond ladder can produce higher income as you purchase new bonds. In addition to higher yields, buying bonds can protect your principal if stocks fall, especially if you own short-term bonds. For example, the NASDAQ is down 9.3% this year, while short-term Treasuries are only down 1.57%.
If interest rates continue to rise, you will have the opportunity to buy bonds at a discount, increasing your total return. For example, if you buy a 10-year bond with a 2% coupon at $100, your current income and yield-to-maturity will be 2%. If rates rise by 2%, the price could fall to $84. If you purchase the bond at $84, your current yield jumps to 2.4%, and the yield-to-maturity increases to 3.9%. It pays to buy bonds at a discount. One person’s trash is another person’s treasure.
What is the top for inflation and interest rates? I don’t have a clue, nor does the Federal Reserve. No one can predict where inflation or interest rates are going. If interest rates continue to rise, consider adding bonds to your portfolio so you can generate more income.
As I mentioned, buying bonds is the ultimate contrarian play because everyone knows interest rates are going higher, but what if everyone is wrong? What if rates don’t rise? What if inflation falls? If you buy when others are selling, you could make money with your shrewd investing skills. Who knows?
Bye, bye and buy bonds.
Bond selection is primarily a negative art. It is a process of exclusion and rejection, rather than of search and acceptance. ~ Benjamin Graham
February 11, 2022
Bill Parrott, CFP®, is the President and CEO of Parrott Wealth Management, located in Austin, Texas. Parrott Wealth Management is a fee-only, fiduciary, registered investment advisor firm. Our goal is to remove complexity, confusion, and worry from the investment and financial planning process so our clients can pursue a life of purpose. Our firm does not have an asset or fee minimum, and we work with anybody who needs financial help regardless of age, income, or asset level. PWM’s custodian is TD Ameritrade, and our annual fee starts at .5% of your assets and drops depending on the level of your assets.
Note: Investments are not guaranteed and do involve risk. Your returns may differ from those posted in this blog. PWM is not a tax advisor, nor do we give tax advice. Please consult your tax advisor for items that are specific to your situation. Options involve risk and aren’t suitable for every investor.