Bond Bubble Threat Larger Than Ever
If you think the Fed saying they will hold rates down for two more years means a bond bubble won't happen, think again. The Fed only controls short-term rates. Though experts have been predicting a bond bubble for the past three years, rates have continued to decline and bonds have surged. Still, I remain concerned that rising rates could devastate bond prices. Here's a little background on rates, as well as some advice on what you should and shouldn't do.
Bond yields plummet
In 2007, the 5-year Treasury yielded over 5 percent. Then came the great recession, and rates fell to 2.80 percent by October 2008. The economy has rebounded a bit and the US Treasury was downgraded by Standard and Poors, yet rates continued to decline. Yesterday, the 5-year Treasury yielded only 0.93 percent. Note - rate is now 0.83 percent as of 10:25 am EDT 8/18/11.
The experts have been getting it wrong for some time now, but that hasn't stopped them from doubling down on bold statements such as the prediction that rates would definitely increase. And since rates most certainly didn't increase, the experts proved to be wrong again as they have been on the direction of interest rates a majority of the time.
Why am I worried?
I have no idea where intermediate and long term rates will be in a few months or next year, so you may be wondering why I'm worried. Well, for three reasons:
- The downside is far greater than the upside. The 5-year Treasury has fallen from 5.0 percent to 0.93 percent, which signals the end of the bond party since rates can't fall below zero.
- The possible downside could be considerable. My favorite bond fund, the Vanguard Total Bond Fund, yields only 2.46 percent but will decline by about 5.2 percent for every one percentage point increase in intermediate term rates. A three percent increase could take 15.6 percent of your money.
- As rates have fallen so sharply lately, the experts have stopped predicting a bond bubble. This could be a particularly bad sign.
Not too long ago, I was reading Investment News and came upon a ProShares advertisement of how I can "help protect your bond portfolio from a bond bubble." They proposed some ETFs such as the UltraShort 20+ Year Treasury (TBT) and Ultrashort 7-10 Year Treasury (PST). It's so obvious that rates have to go up, making us a bundle, right? Riiiight. Had I listened to this advertisement and put my clients in these vehicles, over the last three months alone, they would have lost 23.7 percent and 15.8 percent respectively. Not exactly the role of a bond portfolio.
Cash is King
Cash may be king but the king is dead. Those that left money earning 0.01 percent waiting for the bond bubble to burst, missed out on some great bond returns. Leaving money in cash may feel secure, but cash is actually the riskiest investment in the long run. The illusion of the safe money market is a certain death from taxes and inflation.
The solution
The answer is simple, but don't hold your breath waiting for someone to tell you, because they can't profit from it. And that answer is certificates of deposits (CDs) paying high rates with easy early withdrawal penalties. You can actually have your cake and eat it too by earning intermediate-term or higher rates while taking only minimal risk from rising rates.
My long-time favorite is Ally Bank's 5 year CD with a 60 day early withdrawal penalty. Paying 2.24 percent APY, it yields more than twice the 5-year Treasury and almost as much as the Vanguard Total Bond Fund. Just as important is that the 60 day penalty equates to only losing 0.37 percent. This is far less downside than intermediate-term bonds and bond funds.
Another favorite of mine is the 7-year CD at Security Service Federal Credit Union yielding as much as 3.50 percent APY. The penalty is much stiffer at up to one year but that's still pretty good compared to bonds. Meanwhile, it's yielding almost as much as a 30-year Treasury. One warning is that not everyone can qualify for membership to this credit union.
So the Ally bank CD essentially gives you the right to sell it back to them (put) at a 0.37 percent discount which limits your risk. The Security Service Federal Credit Union comes with a put to sell it back to them at a discount of 3.5 percent or less.
My advice
Your broker, advisor, or fund company can't offer you this solution but it's there nonetheless. DepositAccounts.com is the single best place to shop for rates and get tips on the early withdrawal penalties. Make sure you read the disclosure statement to confirm that there is no right the institution takes to deny your early withdrawal request. If, like Ally Bank, the institution doesn't allow partial early withdrawals, carve up your deposit into smaller CDs. Never ever go above FDIC or NCUA insurance limits, but remember there are ways to maximize FDIC and NCUA insurance and get millions of dollars at each institution.
Though it may seem like rates will be low for a long time, they do have a way of fooling us. My advice is to take advantage of rare opportunities to earn more with less risk. If rates don't go up, you'll still earn more. If there really is a bond bubble, you'll be immunized from most of it's impact.
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