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After the Dow Industrials reached their peak on October 9, 2007, there was a long, painful decline to the trough reached on March 9, 2009.  During that time the DJIA lost 54% but was followed by a rally of 70%. Even with this spectacular run up through 2009, the index never reached it peak. While closer now after a good 2010 it, the peak is still a long climb up the mountain.  In fact, to break even from a 50+% loss requires a disproportionate increase (more than 100%) just to “get back to where you once belonged” as the classic rock song lyrics said.

Investors Win By Not Losing

As this roller coaster shows, its easier to keep what you have than try to rebuild it.  Unfortunately, after such volatility, investors tend to flee to places that are perceived to be safe.  For most that has created a flight to bonds. While investors think of risk as “loss of capital” the traditional views of risk continue to be turned on their head. Sure, you could stash your money away in a money market or under the mattress but what kind of return will that produce?  Will you have enough to eat more than dog food in retirement?

A recent documentary on the disaster at Pompeii and Herculaneum shows how many townspeople fled to the concrete tunnels near the wharves.  Considered a safe place, it ended up as a tomb to more than 300 skeletal remains. These hopeful survivors were trapped by the lava flows which sealed up the tunnels where they had fled.

In many ways, investors fleeing the danger of the markets by shifting to government bonds could be dooming themselves to a similar fate as the Pompeians.

The returns from “safe” Treasuries are pathetic.  Huge investor appetite has driven up to demand and helped lower the yields offered.  A backlash could hurt investors when interest rates rise as they inevitably have to.

If the goal is to preserve capital and avoid dangers, it shouldn’t matter to an investor what asset class is used.  (It’s Halloween.  Watch any scary movie and when the hapless victim is trapped he/she could care less whether the guy in the hockey mask is stopped by a dump truck or an arrow).

In much the same way, we should be looking at other ways to conserve capital.

Carrying Junk Around

Say “junk bonds” to someone and they may be thinking about Michael Milken in the 1980s or businesses on the brink of bankruptcy.  While these bonds are issued by companies with lower credit ratings, they offer a very good alternative to “safe” Government bonds. The point of diversification is to not put all your eggs in one basket.  Today most investors are torn between a savings account paying practically no interest or reaching for yield using alternatives.

The bond market prices the risks of bonds every day.  Currently, the bond market is pricing in a possibility of 6% default risk on junk bonds as a group.  That’s down from its historic number. Some individual bonds of companies may certainly be higher but as a group that’s not a bad number.  Some analysts at JP Morgan Chase have even estimated that the default risk for 2011 is as low as 1.4%.

Why so low? The projected default risk is low in part because companies are showing their highest level of profits in years.  They have shed workers, squeezed productivity gains from those remaining and taken over market share as weaker competitors have failed. The prospects for these companies look even better considering that as a recession ends company cash flows improve.  This means more cash available to service debt. And as these companies improve so too will their credit ratings leading to lower interest rates that they can get when they refinance their debts just like any homeowner would who has an improved credit score.

Avoiding the Danger of a Secular Bear

In a secular bear market, there are rally periods while the markets as a whole may languish or sometimes drop.  During the secular bear from 1/1/1965 to 12/31/1985, a Buy and Hold bond investor would have been whipsawed but ending up gaining about 1 basis point (or 0.01%)  per year for 20 years.  Not a lot of payback for the sometimes stomach-churning ride over that time.

A More Tactical Approach to Risk Management

Not all bonds are the same.  There are government bonds, municipal bonds, US investment grade corporate bonds, US hi-yield/junk bonds, convertible bonds, bonds from overseas and bonds from emerging markets.  Just like every homeowner applying for a mortgage is different and has to go through different underwriting,  the characteristics of all these bonds are different as well.

For instance, hi-yield bonds are more likely subject to credit risk.  Since the rates on these types of bonds are higher than that found on a Government bond or investment grade corporate bond, they are not so sensitive to changes in interest rates.  On the other hand, Government bonds are more sensitive to interest rate risk and the perceptions about expected inflation or the impact of monetary and fiscal policy on future interest rates.

Since these two bond categories are influenced by different factors, they tend to not be correlated meaning that they don’t move in lock-step: When one is zigging the other is probably zagging in the opposite direction.

A key way to reduce risk and potentially increase returns when dealing with bonds is to rotate among the different bond types.  Sometimes the market conditions favor one flavor of bonds over another.  At other times it’s better to reduce all bond types and shift to cash or money markets.

Simply buying and holding means that gains made in one period may be taken away by another. If you’re able to make gains and take them off the table from time to time, you’ll have less money at risk and greater opportunities at preserving capital for the long term.

In the chart below, you can see that buying each of these major bond indexes can produce widely different results.  For nearly the same risk level (as measured by the standard deviation), US High Yield long term bonds have a clearly higher overall return and higher return during periods of higher interest rates than the long-term US Treasury index.

Bottom Line

Investors seeking ways to add income to their portfolio and reduce risk of loss to their capital really need to consider alternatives to buying and holding.  Rotating among these different bond asset types may reduce the overall volatility to the portfolio and preserve capital for the long term.

If you don’t want to end up like the victims of Mount Vesuvius and be buried by a “safe” move, you should open your minds to understand all the risks and ways to manage them.

Figure 1 (Source: BTS Asset Management Presentation/Nataxis Global Assoc, 10/27/2010)

Bond Index Annualized ReturnNov 1992 – Aug 2009 Standard Deviation (measure of risk) Annual Return During Rising Rate Period
BarCap US High Yield Long 10.45% 10.94 6.75%
BarCap US Corp Baa Investment Grade 6.97% 6.31 1.75%
BarCap US Aggregate Bond 6.46% 3.82 1.31%
BarCap LT US Treasury 8.11% 9.28 -0.40%

Figure 2 (Source: BTS Asset Management Presentation, 10/27/2010)

Bond Sector Credit Risk Interest Rate Risk Currency Risk
US High Yield High Low None
International Developed Market Low Medium High
Long-term US Government None High None
Emerging Market High Low High
US Municipal Low High None
US Investment Grade Corporate Low High None

Figure 3 (Source: BTS Asset Management Presentation, 10/27/2010)

CAPITAL PRESERVATION KEY to LONG-TERM SUCCESS
Loss Gain Needed to Get Back to Break Even

(15%)

+ 18%

(20%)

+ 25%

(30%) + 43%
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Given the roller coaster ride that stock market investors have experienced and the negligible rates offered by banks on savings, it’s easy to see why someone might want to use their cash to pay off their mortgage.

Being debt free is not only noble but can provide a buffer in tough times since you’ll have one less cash outflow each month.

For every dollar you pay off in a mortgage, your rate of return is equal to the amount of interest that you’re saving. This is measured by the interest rate (net of the amount that is deductible of course).

So in this example, you could be “earning” 6.125% (less the deductibility of the mortgage interest based on your tax bracket).

Compared to other savings alternatives, that’s a great return. And compared to other equity investments it can seem a lot less volatile.

But before you drain the cash reserve, let’s look at this more closely.

  1. Tying up a lump sum of cash in a property can be risky. You may come up short on emergency reserves by using the bulk of it to pay off the loan.  Will you have enough cash to cover 12 months of your living expenses?  Will you have enough to cover operating expenses for the properties if they were vacant or you lose your job?
    • Considering that in this case you have three other investment properties and your primary residence, there is always the likelihood that you might need cash for an emergency repair or the cost of compliance with any changes in building codes or prepping a vacant unit for a new tenant or even to cover the carrying costs while a unit is vacant.
  2. Real estate is an illiquid investment. Once you send in the check to the bank you no longer have the cash readily available for use either to pay for ongoing expenses, cover emergencies or for other investment alternatives that may come along.
    • What if a really good deal on another investment property came along?  Depending on your market, you could find a very inexpensive property to buy that could more easily cash flow now but without the cash you’re out of luck. Sure, you’ll have more equity but to tap into it will require a bank to agree to give it to you which is more difficult on investment properties and your primary residence may not have enough equity to allow you to get a home equity line of credit (HELOC) or home equity loan to recoup the cash you may need.
  3. Property prices are still in flux.While savings bank rates are abysmal, losing money is even less appealing. By investing more in your property, you could actually see a negative return.  In some markets, real estate prices are still going down so it is conceivable that you could turn each $1 paid in principal into 90 cents.

What Are the Alternatives?

Consider a non-bank financial firm that is offering one of those ultra-high yield money markets for a good portion of this reserve fund.  It’s accessible and won’t cost you anything to hold and they tend to offer higher rates than most brick-and-mortar banks.

You could also split off a portion of the funds and find a ultra-short term bond mutual fund.  Average yields are about 2%.

For a small portion (starting at around $2,500) you could even use a convertible bond fund.  These are hybrid investments combining the fixed income of a bond with the potential capital appreciation of a stock.  These types of investments have held up well when interest rates rise because of Fed action or inflation.

For more information on these, you could check out my article posted on www.ezinearticles.com here.

Likewise, you could also consider other types of short-term bond investments like mutual funds that target floating rate notes.  These types of commercial loans are regularly reset and are a good way to hedge against inflation.  Since there is credit risk, you don’t want to put a whole lot of eggs in this one basket but 5% to 10% of your funds is prudent for you to consider.

As in all things, read the prospectus and speak with your adviser to determine if these are right for you in your situation.

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