“So I should be 112% in stocks, right?”
That’s what I asked my dad at the tender age of 8…
I was starting to read books about investing. And one book suggested that investors take 120 and subtract their age.
That’s how much the book suggested investors have in stocks. The rest? Into bonds.
I’ll admit… I never put more than 100% of my wealth into stocks. But I also didn’t touch bonds until I was 30.
One of the hallmarks of the Palm Beach Daily has been to warn investors to avoid bonds like the plague.
Why? It’s simple… bonds were one of the biggest bubbles in the pre-covid markets.
The nearly non-existent yields offered no real inflation-adjusted return… unless you were willing to buy bonds with a high risk of default. For years, most bonds haven’t made sense for everyday investors to own.
Yes, the certainty of a payment sounds great. Especially with a volatile stock market… and yet another crypto winter unfolding.
But now that bond bubble is popping. And it’s creating far more opportunities in the space than we’ve seen in the past decade. It’s starting to become a different story.
We’re not quite there yet. That’s because bonds still aren’t priced to beat today’s inflation levels. With the latest inflation read at 7.1% and 10-year Treasury bonds yielding 4.13%, real rates sit at -2.97%.
But if inflation comes down in the next two years… and the Fed stops raising interest rates… bonds should provide substantial real returns.
Interest rates and bond prices are inversely correlated. When interest rates go up, bond prices go down. And when interest rates go down, bond prices go up.
If you want to own bonds for safety, buy and hold for maturity. But if you can be on the right side of this cycle, you can make a bundle in bonds in a short time frame. You can lock in a higher yield for 1–2 years and see an upside of as much as 40%.
Why the Bond Market Will Turn This Year
Eventually, today’s rising interest rate regime will end. The biggest reason for this will be the exploding cost of financing the government’s debt.
Right now, the total federal debt (excluding unfunded liabilities) is $31.4 trillion.
LPL Research estimates the federal government will spend over $1 trillion in 2023 just paying interest on that debt.
There will be rising political pressure on the Fed to pivot as we hit the psychological barrier of $1 trillion in interest payments.
Meanwhile, we’ve seen the yield curve invert. When the yield curve inverts, long-term Treasury yields fall below short-term Treasury yields.
And inversions have preceded every recession since the 1950s. That’s a 10-for-10 perfect indicator.
That’s a sign we’ll likely move into a recession next year. And it’s another reason we believe the Fed will have to stop raising rates.
That’s why I’m confident 2023 will be a great year for bond investors.
Right now, investors can nab the highest bond yields since the housing market bust in 2008. And as yields fall (remember, bond prices move inversely to bond yields), we could see double-digit capital gains.
I first learned about this cycle at the age of 30. That’s about the time I bought some of my first bonds. A company called Digital Realty Trust (DLR) had a debt offering that was trading for about 80 cents on the dollar.
I had watched the company for nearly a year and considered investing in shares.
I knew that DLR was facing some short-term headwinds on a temporary fear regarding the strength of the growing cloud services market… and that sentiment would change in time.
It was yielding nearly 7%… and within a year, it had gone back to par, and I closed it out. Overall, I made just over 25% in a year. That’s the power of buying a bond when prices are low.
A Low-Risk Way to Profit From Today’s Bond Market
The market has changed so fast that you can make a ton of money in bonds in a short time. Fortunately, you don’t need to take on an insane amount of risk.
For instance, cautious investors can lock in yields of nearly 7% on I-Bonds.
The Treasury launched them in 1998. They’re virtually guaranteed to keep pace with rising prices as measured by the Consumer Price Index (CPI).
The interest comes from two components that are adjusted every six months. The first is a baseline interest rate. It’s largely been 0% for more than a decade.
The other component is the inflation-pegged interest rate. It varies over time depending on the Consumer Price Index for All Urban Consumers (CPI-U). The new rate is announced every six months on May 1 and November 1.
Currently, these bonds yield 6.89%, down from 9.62% from May through October.
If you put the maximum of $10,000 in an I-Bond last year, you’d be looking at an annual income of $962. Today, it’s $689. It will likely reset lower in May.
That may not seem like much. But even with rising rates, today’s 6.9% yield is nearly 1.7 times higher than the 10-year yield of 4.13%. And 3.8 times higher than the 1.82% dividend yield of the S&P 500.
You’re allowed to buy $10,000 in I-bonds annually. Again, the rate will likely drop again in May, so you have until then to hit the maximum limit and lock in the 6.89% rate.
As interest rates continue to rise into 2023, look for the opportunity to buy long-dated bonds, both government and investment-grade corporate alike. Why? They’ll be the most sensitive to the next move lower in interest rates, which could occur by the end of 2023.
That’s how you can make a killing in the bond market – not by holding to maturity but by mastering the cycle.
Good investing,
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Andrew Packer
Analyst, Palm Beach Daily