If you're looking for
yield, the advice often seems black and white – either stay
away from bonds to avoid the inevitable rise in interest rates, or jump right
in as the Fed isn't moving rates until mid-2015. But as with many things in
life, there's a gray area in between. Yes, bonds will get crushed by higher
interest rates, but it's possible that alternatives could be crushed even
more.
The alternatives to bonds
are few and unattractive. A certificate of deposit (CD) paying below the
inflation rate just isn't going to cut it. What many investors find themselves choosing seems like the next best thing:
dividend-paying stocks. However, is this a solution or simply jumping from
the frying pan into the fire?
Well, it depends. By
entering the equity markets, you're taking on much more risk than a bond. In
the Miller's Money Forever portfolio, we hold both dividend stocks
and short-term bond funds to balance the risk of each. Both asset classes
have considerable risks. In the case of bonds, it's
interest-rate risk, as higher interest rates mean lower bond prices. In the
case of equities, it's market risk. Sure, your
stocks may be immune to interest-rate risk, but that won't protect one from
the market if it were to crash 30% tomorrow.
When it comes to
evaluating risks, bonds do have one advantage over equities: measurable risk
prior to a loss. Bond funds typically list a characteristic known as
"duration." In the most simplified definition, duration is the
change in value of a bond for a one-percent change in interest rates. So, if
a ten-year, intermediate-maturity bond fund has a duration
of 6, a one-percent increase on ten-year bond rates in the market would
result in a 6% decline in the value of the fund.
By understanding
duration, you can plan ahead for the possibility of rising rates. One can
pick either shorter-maturity bond funds or higher-yielding funds which will
have a lower duration. Being able to evaluate duration is a huge advantage in
assessing your risks. For example, if interest rates rise by three percent in
the previous example, you can estimate a loss of 18%. What's so advantageous
about knowing that?
Consider the
risk-estimation problem with the alternative – dividend-paying stocks. If
there's a full-blown market crash tomorrow, how much will you lose? Even
defensive stocks could lose 20%, 40%, or maybe 50% or more. If you've been
dipping into riskier dividend stocks promising higher yields, you could see
70% losses... or more. The point is that your potential loss is open-ended
and unknown.
So, here's the pickle for
yield seekers out there. Higher rates are pretty much set to hit by mid-2015,
so bonds will slowly get crushed by rising rates. But the same thing might
happen to equities – who is to say the market will
keep rising until mid-2015?
When someone suggests
that you should exit bonds for equities in fear of rising rates, there's an
unstated underlying assumption of a stable stock market for the next two
years. As we pass the all-time highs on the DJIA and S&P 500, I'm getting
a little nervous about that assumption. If you think that the market is
slightly overvalued now, where do you see it by mid-2015?
In comparison to the
potential losses on dividend equities, a bond fund losing 18% doesn't sound
like such a travesty anymore – especially if you cut your losses even earlier
at the first sign of higher rates. Now, this isn't to say that bonds are the
way to go and you should forget about equities. Instead, the point is to
realize that you're simply trading one risk for another by leaving bonds for
dividend equities.
By avoiding bonds
altogether and getting your entire yield from equities, you're taking on lots
of market risk. By staying only in bonds, you're taking on a huge amount of
interest-rate risk. In the Miller's Money Forever portfolio, we've
chosen to derive our yield from a hybrid approach – a few low-duration and
low-maturity bond funds, as well as plenty of defensive dividend-paying
stocks.
No matter how the market
turns, we'll be in pretty good shape. If interest rates rise in mid-2015,
that would probably mean the market is in better shape and the Fed is
comfortable enough to raise rates, i.e., the stock market is doing
pretty well. So, while we might lose on the bonds, capital gains on our
dividend-paying equities will likely more than make up the difference. The
opposite is true to a lesser extent. If the market crashes, rates will be
pushed down even more, giving our bond funds a small boost. These gains on
the bonds wouldn't make up for the losses on the equities, but they would
help to soften the blow.
Note that this discussion
is most relevant for those seeking yield and principal protection. If you're
searching for capital gains, you're just not going to find it in bonds at
today's rates. While the two sides of the argument are often portrayed as
black and white, there are good reasons for a yield seeker to hold bonds as
well as dividend-paying equities. This asset allocation doesn't need to be an
either-or decision.
Some cash in very
short-term bond funds still makes sense; one just has to be extremely
selective in choosing the bond funds. That's why we recently published two
special reports called The Yield Book and The Cash Book. Part of our mission in these
reports was to find the very few bond funds that are worth choosing, given
the fact that rates are set to rise within a few years. These reports aren't
about being a bond bull, but rather earning a little interest on cash otherwise
collecting dust, while minimizing interest-rate risk.
The reports are
individually $29, but subscribers to Miller's Money Forever (a $99
annual subscription) receive both reports for free. In Money Forever
(learn more about it), we also include several
dividend-paying stocks, with one yielding as high as 5.7% since our original
purchase price.
Regardless of whether you
sign up, the key takeaway here is that there is no perfect answer to yield in
this environment. The solution is not all bonds or all equities. It's about
understanding the risks in each asset class and adjusting your portfolio
accordingly. Most of you already understand the general risks in the stock
market – 2008 was a harsh master. However, your homework tonight is checking
the duration of your bond funds to assess your risk level there. Then, take a
step back and see whether your portfolio needs some readjustment, perhaps to
very short-term bonds or a little bit more equities.
