There’s been a bloodbath in bonds the last few months…
And it’s not an exaggeration to say the bond market is going through its own 2008-style financial crisis.
It isn’t a crisis of defaults. It’s a crisis of crumbling bond values. That’s because as interest rates go up, bond prices go down.
So when interest rates go up a lot – like the 10-year Treasury yield going from 0.50% to over 4% in the last 12 months – it destroys bond prices.
Assuming you bought a 10-year Treasury last year at 0.50%… today, that bond has dropped as much as 21.4% in value.
Now, that’s not a problem if you plan to hold the bond to maturity. You’d get back 100% of your investment if you did that.
But it’s a huge problem if you borrow against the value of your bonds.
This problem almost decapitated the U.K. financial system when a rapid rate hike vaporized prices on the 10-year gilt (U.K. government bonds).
The 10-year gilts dropped as much as 9.2% in a single week, and the 30-year gilt fell as much as 23% over two weeks, threatening to make the U.K.’s $1.3 trillion pension fund sector insolvent.
But the problem wasn’t the bonds… The problem was the leverage investors put on the bonds to maximize returns.
As gilt prices cratered, it triggered massive margin calls. The Bank of England had to step in to prop up bond prices in an all-out effort to stave off what could have been the beginning of a wide-ranging systemic financial meltdown.
Here’s why I’m telling you this…
A Ticking Time Bomb
For nearly a decade, I’ve warned average investors that they’re making a terrible mistake regarding bonds.
They’ve been buying an asset they believe can’t go down in price.
From 2000 to 2020, the U.S. corporate bond market grew from $1.6 trillion to $6.9 trillion… an investment many Americans think is 100% safe.
And guess who owns most of these assets? Retirees.
Their portfolios are stuffed full of long-dated, low-interest bonds.
Since 2015, I’ve sounded the alarm on these “safe” assets. I’ve risked professional ridicule to steer you away from these securities.
I’ve called them a “ticking time bomb” that could go off any moment. And the resulting chaos would lead to an “income extermination.”
Fast forward to 2022… And the ticking bomb I warned about has exploded.
As you can see in the chart below, bonds have suffered their worst rout in decades… Over $7 trillion has been “exterminated” in the past 11 months.
In 2015, I was way early on my bond call… but I won’t apologize.
Back then, the 10-year Treasury had an average yield of 2.14%, and the 30-year had an average yield of 2.84%.
If you own those bonds today, you’ve seen their value drop by as much as 14% and 26%, respectively… the latter as measured by the iShares 20+ Year Treasury Bond ETF. Those losses jump to 32% when you account for inflation (and you always should).
The risk/reward ratio has been so negatively skewed on bonds that unless you were a seasoned bond trader… you were much better off just leaving them out of your portfolio.
That’s why since 2015, I’ve been warning that rising interest rates were the biggest threat to bond investors.
As I mentioned, interest rates and bonds are inversely correlated. When interest rates go down, bond prices go up. And when interest rates go up, bond prices go down.
To combat record-high inflation, the Federal Reserve has begun jacking up rates. And that’s driving bond prices lower.
Fed Chair Jerome Powell has made clear inflation is his No. 1 concern. That means we’ll see bond prices decline further as he raises rates – at least in the short term.
This bond market reckoning is beginning to make bonds interesting again.
That’s why I’ve started to move part of my money into the bond market. I’ve been able to take advantage of yields I haven’t seen in more than 15 years.
Why I’m Watching Bonds in the Year Ahead
Recently, I’ve been nibbling into some 7% yield to maturity bonds… but I’m not ready to commit large capital yet.
I don’t think the Fed is done raising rates. I also believe we may see some high-profile bond fund blow-ups that could lead to incredible buying opportunities in the bond market.
As I’ve reacquainted myself with individual bond issues, I’ve seen globally recognized, investment-grade companies with 6% and 7% yields to maturity.
That’s an incredible return when you understand just how little risk there is in owning investment-grade bonds.
According to S&P Global, the highest default rate on an investment-grade bond was just 1.02%.
I would say wait if you’re itching to wade into the bond market right now.
Recently, bond prices have rallied strongly as we’ve seen the 10-year yield drop from a high of 4.2% to a recent low of 3.4%. This has caused a big drop in yields with a corresponding increase in prices.
Bonds I bought eight weeks ago for $664 per bond with a 7% yield to maturity are now trading at $796 per bond with a 4.9% yield to maturity.
I don’t think that rally is sustainable, so I’m holding a lot of short-term (30-60 day) government bonds. I’m waiting for rates to spike again… and when they do, I plan to deploy my short-term funds into long-term investment-grade bonds yielding over 6%.
Another important note I want to share with you about bond investing is to keep clear of most bond funds.
If rates end up going much higher for far longer than expected… you could be stuck with lifelong losses.
Here’s why…. when you own an individual bond and rates go up, you can always be made whole by simply holding the bond until it matures.
At that point, you receive the full face-value of the bond. You don’t have the option when you own a bond fund. If the fund manager decides to sell the bond for a loss… guess who eats the loss? You do.
For now, I suggest sticking to individual investment-grade bonds only. There will be a time when it makes sense to buy high-yield (junk) bonds… but I don’t think that’s now. That’s because during a recession, junk bond default rates explode higher.
I believe we’re in a mild recession already. But if the Fed keeps rates high for an extended period, we will see a more serious recession, and that is when you will see some tremendous bargains emerge within the junk bond market.
But we’re not there yet.
Bottom line: 2022’s rapid interest rate hikes made for a terrible year for bond investors. But going forward, we see opportunity in bonds – which hasn’t been the case for decades.
Let the Game Come to You!
P.S. While we wait for bargains in the bond market, a different asset class has outperformed all my traditional investments combined over the last two years… and I don’t expect that to change any time soon.
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