You heard it here: If you have any bonds past 10-year maturities, now is the time to sell. At our firm, we are taking a stand because we are convinced that waves of total-return bond investing, enjoyed by many over the last 20 years, are gone for some time. It was a good strategy through 20 years of consistent downward trending of interest rates, but not much room is left for interest-rate reductions.
Many may recall that 1982 was the year that interest rates reached a high point. That was (gulp) 20 years ago-I guess we are all growing more senior. The inflationary environment of the 1970s had sent interest rates up year after year for about 10 consecutive years. The effect of this trend was that many investors became conditioned to assume that rates would continue to move in this fashion.
Income investors at the time were reluctant to buy bonds with longer maturities. Because interest rates were continuing to rise, many investors didn't want to be locked into long-term bonds at "last year's lower rate" prior to 1982. Furthermore, many weren't interested in the growth potential of bond values because the high interest rates were providing stellar coupon rates. If, at this point, the income investor of 1982 had possessed the foresight to say, "Give me this 14-15-16% return and lock it in for 30 years," he would have made healthy yields and total return yearly, as interest rates began a slow, 20-year descent.
Today, interest rates are as low as they have been in many of our clients' lifetimes. We have seen a steady decline in rates over the last two decades (except for a few "hiccups" on the road down), punctuated by a drastic drop over the last few years. Just as the 10-year stretch of rising rates from '72 to '82 could not be sustained forever, today's rock-bottom rates are likely to be temporary. Dispiriting as it may sound to investors seeking a haven from equities, the climate now is wholly inappropriate for the investor who is accustomed to making favorable total-return investments in the bond realm. The days of growth through underlying appreciation at the hands of Greenspan rate cuts have passed. So, too, have the days of high-yielding, high-quality bonds. We believe that today, the only way to get total return out of bonds is through underlying appreciation from other sources.
If you expect to continue to make money in bonds as a result of falling interest rates, then you probably also believe that rates are headed down to 1% or 0.5%. We don't believe this is likely. For the Fed to engage in such drastic easing, our economy would have to be suffering far worse ailments than it currently does. It would take an economy at a near standstill to prompt the Fed to act in such a fashion. As advisors, we are urging investors to abandon long-term bond investments and yield-seeking mentalities as much as total-return bond investing strategies that rely solely upon declining interest rates. Perhaps the most prudent strategy in this economic climate is to keep maturities short on all bond investments until the next trend is clearly defined.
The most common question prospective clients ask me, as a retirement investment advisor, is: "What is the highest-yielding bond you can get for me? I am rate shopping." At first glance, it seems logical to seek the highest possible yield. After all, it is a long-held tenet that retirees (as investors go) are best served by the maximum level of predictable income.
Perhaps this is why so many retirement-minded investors are conditioned to be "yield seekers." However, these bonds usually offer the highest yield because they represent the highest risk. In truth, the yield-seeking strategy is deceptively oversimplified, especially when viewed against the backdrop of the current economic environment. As with any investment, the risk of loss of principal increases proportionately with increased returns.
Many longtime clients may recall what happened in 1994. Interest rates were on the rise, and many investors bought 30-year bonds after the Fed stopped acting in 1995. Rates then did an about face in 1995 and continued to fall to the present low level, and these maneuvers often proved profitable. It was a "hard sell" to persuade folks to break away from their quest for the maximum yield.
Yet, history shows that there were strategies that brought more favorable results than simply seeking the maximum yield. Those who forget history are doomed to repeat it. Today, we strongly believe that the same environment will exist in 2003 as it did in 1994. It is our contention that rates will begin a period of upward motion beginning in 2003.
It is also important to consider the impact that GDP has upon the nature of bond investing. Sometimes in a poor economy, high-yielding bonds will not move up in value. In a diminished GDP environment, high-yielding, fixed-income instruments suffer due to increased uncertainty about issuers' ability to service their debt. For the yield seeker, expectations of appreciation from a favorable move in interest rates are not always met. Even though interest rates may decline, you can't always count on appreciation in your corporate bonds. The yield seeker looks for the lowest rating (B, BBB, low-quality/high yield) without much expectation of quality improvements as yield curves change. The reason for this is because when rates fall and bond values rise, the effect on low-yielding corporate bonds is not always positive.
The first beneficiaries of a slow GDP are high-quality (AAA) Treasuries, and the second beneficiaries are high-quality corporate bonds. Sometimes, as GDP improves, you may not see a movement up in high-quality bonds at all. Clearly, simply clinging to the notion that the highest yield is the best route to travel may be a damaging strategy in today's environment.
My function, ultimately, is to act as a historian and economist as much as an investment professional. For it is only through the study of historical and economic happenings that we can realize the exceptional opportunities that many others fail to grasp.
John Valentine owns Valentine Capital Retirement Planning Group Inc. in San Ramon, Calif.