Bond Investing

The U.S. Census Bureau’s American Community Survey found the national median income is down 5.1% over the last decade.

It also found the number of Americans developing and collecting passive income has fallen to levels not seen in decades. Only 24.2% of American households collect income from rent interest or dividends. That’s down from more than one-third of the country a decade ago.

At the same time, more households than ever are becoming dependent on passive income to maintain their quality of life. Tens of millions of baby boomers crossing into retirement will have to earn more income from their investments just to maintain their standards of living.

And many have already started: Massive amounts of money have been pulled out of stocks since the downturn in 2008. Investors have put more than $670 billion in new capital to work in bond funds in the last three years — a massive amount compared to the normal range of $30 to $50 billion per year over the last decade.

The search for yield is going to keep the bond market booming for years to come…

And it’s going to pay off handsomely for investors looking at “boring” bonds now.

Interest Rates: How Low Can You Go?

The primary reason we expect the bond bull to continue is that the dominant market trend for the next decade is financial repression.

Remember, financial repression brings with it negative real interest rates, increased government involvement in the economy, reduced access to capital for businesses and consumers, slow GDP growth or worse, and a global economy that jumps from panic to panic for years — if not decades — to come.

You’re feeling it already. Low interest rates, minimal yields, and heightened stock market volatility are all part of it. After all, why can’t you get any yield in CDs, government bonds, or anywhere else?

Interest rates are being held artificially low to “help” the economy.

This didn’t work in Japan for nearly 20 years. It helped drag down economic growth throughout the Great Depression. And it hasn’t helped much in the past three years.

But if the recent actions by central banks are any indicator, rates are going to be held as low as possible for years to come. And it’s going to keep the bond boom going strong.

Not “Junk” Anymore

Corporate bonds have done extremely well —  and are poised to do much better than the overall markets.

I know what you’re thinking…

Bonds are boring. Most don’t pay much interest. And if interest rates rise (which they will eventually), the value of bonds will be destroyed very quickly. (If interest rates double, bond prices are cut in half.)

But there’s the thing: High-yield bonds are performing exceptionally well.

Now, I realize high-yield bonds usually yield a high rate of interest because they’re risky. The perceived risk of default is normally far greater than government bonds and investment-grade corporate bonds issued by cash cows like IBM and Wal-Mart.

They are called “junk bonds” and have an equally terrible reputation.

During certain time periods, however, they perform exceptionally well.

A period of low interest rates — like the one we’re in now — is one of those times.

For example, the SPDR Barclays Capital High Yield Bond (NYSE: JNK), an ETF which follows the junk bond market, currently yields 7.43%.

That’s nearly three and a half times more yield than the 10-Year U.S. Treasury Bond.

And despite the implied risks of higher interest rates, junk bonds have been doing extremely well. Since the stock market topped in October 2007, the S&P 500 is down almost 20%. Junk bonds, as a whole, have returned more than 34% over the same time period.

And this will continue because despite their performance, high-yield and junk bonds are particularly cheap right now.

Anatomy of a Bond Price

The key to determining the value of a high-yield or junk bond and the interest rate you should expect in return is the default risk.

After all, if you’re lending to Greece, you’re going to want a 30% (or more!) interest rate to cover the high risks of default.

Corporate bonds, however, are much more reliable than debt-engulfed sovereign debts…

The National Bureau of Economic Research recently published a study which found corporate bond default rates are surprisingly low. It found the average default rate is about 1.5 percent between 1866 and 2008.

If you take out a few major panics like the Great Depression and 1870s railroad crisis, when total default rates soared to above 30%, default rates are even lower.  History tells us that bonds are remarkably consistent and safe.

Even during the current economic malaise, bonds are set to continue their extremely reliable run.

Moody’s just announced it expects an increase in global corporate bond defaults to 2.4% next year. For high-yield and junk bonds, the numbers are even better. The default rate on junk bonds is on pace to post a near-record low of about 2% in 2011. That’s below its long-run average of 5%.

Remember, central banks are doing everything they can to keep the gears of credit lubed as efficiently as possible. Defaults are the sand in the gears — and what they’re doing everything in their power to prevent.

The net result is the continuation of a trend most investors who only focus on stocks will never realize: During tough times, bonds can deliver far better returns with much less risk.

This trend will only continue to improve.

Revealed: The 128% Bond

Back in August, right when post-QE2 volatility began to surge, we first started talking about alternative investments where you can get extra return safely.

One of those areas was to combine bonds and Closed-End Funds (CEFs) to get into a diversified portfolio of bonds at a discounted price.

In “If You’re Buying Stocks, You’re Making a Big Mistake,” we found:

This often overlooked corner of the market is currently safer than stocks. It offers significantly more upside than stocks. And when it has fallen to current levels in the past, investors were handsomely rewarded.

At the time, the euro-induced selling fever had pushed the discounts on CEFs to relatively extreme highs not seen since the 2008 credit crunch. And the CEFs, which invest primarily in diversified portfolios of corporate bonds (which makes them inherently less risky than stocks), were trading at even greater discounts than many.

The fund we focused on was a bond fund that buys convertible bonds — bonds that can be “converted” to stocks if the underlying company’s stock price goes up. We like this fund because it has been a consistent performer, even in the toughest markets.

Since your editor initially bought it, the Calamos Convertible and High Yield Fund (NYSE: CHY) has returned more than 100% in capital gains and more than 15% in dividends income.

The total return over the three-year period: 128% — that’s right,  more than double your money from bonds.

Bonds are great, but they aren’t perfect… No investment is.

The Worst-Case Scenario

Now, I realize bonds are at extreme highs and their yields are at extreme lows.

As we looked at last week, Treasury Inflation Protected Securities (TIPS) have negative yields.

It would appear there is only one way for interest rates to go: up.

And when interest rates rise, bond values can fall very quickly.

Of course, interest rates are at historic lows and can stay at them far longer than most investors expect. At this point, it looks like they will.

That’s why high-yield bonds are appearing better than stocks, even if interest rates rise.

A study by Fidelity Investments found that during the last period of rising interest rates (1941 to 1981), bonds only fell four out of those 40 years. And each year bonds fell, the worst was a loss of 5%.  

As I said before, bonds aren’t perfect; but they will be about as close as you can get to “perfect” for the current market environment.

Join the Yield-Chasers Now

In the end, investing and speculating is nothing more than predicting which assets will be in demand in the future — and buying them now.

There are all sorts of assets that will be in demand going forward. For example, gold, silver, and commodities like oil are going to become increasingly popular as inflation pushes real asset prices up (another impact of near-zero interest rates).

Finally, high-yield and junk bonds will continue to increase in demand as the population gets older. Retirees’ disposable income is declining, and they’re going to be induced by central bank policies to search out maximum yield to maintain their standards of living.

There are still opportunities in this market. The yield-chasing trend is still in its early stages. If you are looking for safe and consistent gains, the time to buy is now.

Good investing,

Andrew Mickey
Editor, Wealth Daily