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Now’s a Terrible Time to Own This Popular Investment

By Chris Lowe, Editor-at-Large on September 8, 2014

Savings Bond. Source: Wikimedia.

Savings Bond. Source: Wikimedia.

To Bill’s advice against buying stocks selling for more than 20 times earnings we offer an addendum:

Steer clear of bonds when the yield on the 10-year Treasury note is under 2.5%… the average yield on investment-grade corporate bonds is just over 3%… and the average yield on junk bonds is just over 5%.

As Kathleen Gaffney, portfolio manager of the Eaton Vance Bond Fund, warns, credit markets today are “extremely overvalued.”

And as regular readers will know, although extreme valuations are poor market-timing indicators, they’re a big killer of long-term returns.

When you boil it down, there are only two possible outcomes if you’re a bond investor.

Either you buy a bond and hold it to maturity. Or you buy a bond and sell it on to another investor before it reaches maturity.

And either way, investors are blindly taking big risks in the bond market right now.

Let me explain…

If you buy, say, a 10-year T-note and hold it to maturity, your return will be made up of the repayment of your principal after 10 years and the income you pick up along the way.

Given that the official rate of inflation is running at 2% over the last 12 months, your best-case scenario – providing the Fed doesn’t let inflation fall – is a flat real return after your bond matures.

And if inflation picks up, you’ll be left with a negative real return.

If you buy the same 10-year T-note and sell it on before it matures, you risk getting less back for your bond than what you paid for it.

That’s because as interest rates rise, so does the yield on newly issued 10-year T-notes. So, to compensate potential buyers for the lower yield on your bond, you must offer to sell it at a discount to the price you originally paid for it.

That’s why as interest rates rise, bond prices fall.

But it gets even worse…

You see, a lot of folks aren’t happy with earning 2.4% in the Treasury market. So they’ve been “reaching for yield” in riskier areas of the bond market, such as junk bonds – where it’s possible to earn a yield of about 5% by taking on higher default risk.

This has led to record issuance of junk bonds… and, of course, a record number of junk bonds being held by investors.

If investors all want to get out of these riskier bonds at once, bargain-hunter buyers are going to want a steep discount in exchange for taking those bonds off sellers’ hands. And this means a big gap down in prices…

So, what should you buy instead of bonds?

The answer might surprise you: nothing. With such high valuations in the bond market right now, you’re better off holding cash and using it to pick up bargains when the next downswing in the market kicks in.

As resource-investing legend Rick Rule put it at a private meeting of members of Bill’s family wealth advisory, Bonner & Partners Family Office, cash gives you two things – the courage and the ability to pick up bargains when the market starts to put assets on sale.

Without cash on board, you can’t hope to take advantage of that opportunity.

Right now, given the kinds of valuations we’re seeing in both stocks and bonds, consider having about 15-20% of your portfolio in cash.

Not only will it reduce your risk of losses in a market correction, it will also allow you to make outsize gains in the next upswing in prices.

P.S. Don’t forget to get your Kindle edition of Bill’s new book, Hormegeddon, on Amazon.com. Here’s that link again.

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