The atmosphere is casual and eclectic and the food is some of the finest gourmet fare you will find anywhere. If you’re ever in this part of South Florida, don’t miss it. And order the crab cakes (Even if you think you’ve already tasted the best in the world).

But I could tell that Rusty McDougal, our resident natural resources expert, had more on his mind than a great meal and the Alexander Valley cabernet the waiter was pouring in his glass. He wanted to know how Steve McDonald intends to run a successful bond investing service in a rising interest rate environment.

And maybe you wonder the same thing. As inflation heats up and interest rates rise, bond prices fall. For most bond investors, rising interest rates are bad news. And with the federal-funds rate near zero and long-term interest rates near 50-year lows, the most likely path for interest rates is up.

So, how does Steve intend to continue leading his subscribers to prosperity in such a scenario, Rusty wanted to know. Steve’s explanation is well worth your consideration, because what he has developed is a bond strategy that doesn’t suffer… it actually thrives during inflation!

Steve’s strategy is based on four primary tenets:

•    Buy investment grade bonds only (no junk)
•    Buy at a discount to par value
•    Buy bonds with a short time to maturity
•    Create a “laddered” portfolio

Before I explain how it works, I should begin with a brief discussion of the basics.

Virtually every bond is issued at a price of $1,000 (par value). Bonds are quoted as a percentage of par. So, a quote of “100” equals $1,000… “85” equals $850… and a bond quoted at 89.50 will cost you $895.

Once a bond is “on the market,” its price can fluctuate up or down. However, the volatility in bonds is about 1/20 that of stocks. Bonds prices fluctuate for the same reasons that stocks do. They respond to changes in the company’s fundamentals, changes in the economic environment, and changes to interest rates. And as long as you hold the bond to maturity and the company is not bankrupt, they are legally obligated to pay the full $1,000, plus interest on a semi-annual basis – no matter what happens to interest rates, the economy or the market.

So, let’s look at Steve’s strategy in detail to see how he has been able to generate two to four times the long-term return of the stock market (with a fraction of the risk) and why his strategy is designed to flourish in a rising interest rate environment.

Investment Grade Only

The long-term default rate on “junk bonds” is around 5%. Stated another way, 95% of all junk bonds make interest payments right on schedule and pay in full at maturity. That is a pretty good record for a designation of “junk.”

However, investment grade bonds have an even better track record. According to a study by Moody’s the long-term default rate on investment grade bonds is less than 1%. On a historical basis, that means 99% of investment grade bonds have fulfilled their obligations to investors. Compared to the stock market, bonds are a virtual sure thing.

Buy at a Discount to Par Value

When you buy a bond at a discount and the company pays in full at maturity, you add a welcomed capital gain to the regular interest payments you receive. This is the key to beating long-term stock market returns with bonds – buying high-quality bonds at a significant discount to achieve a high total return.

Buy Bonds with a Short Time to Maturity

Steve recommends bonds with a time to maturity of 12 to 36 months (and never more than about four years). Loading up on long-term bonds is extremely risky. If inflation takes off, you’re dead. You’ll be holding bonds that pay below-market rates, and you would have to sell at a loss to do anything about it. Price inflation and rising interest rates are coming. Stick to short maturities.

Create a “Laddered” Portfolio

Your bond portfolio should be laddered. The concept is quite simple. It means you should never load up on just a few bonds, because you like the yield or the company that issued them. Instead, buy many different bonds and spread the maturities out. Ideally, after about a year, you should have money coming due every month or two that you can re-invest.

Now, let’s review how this combined strategy can beat long-term market returns hands down (And help you stay well ahead of the ravages of inflation).

Because you are buying “investment grade” bonds, your return is virtually guaranteed. You will know exactly how much you’re going to make and exactly when you are going to be paid. By investing in these bonds at a discount, you can add a significant capital gain to your interest payments, creating a high total return. And by sticking to a laddered portfolio with a short time to maturity, you will frequently have new money coming due that you can put back to work.

The reason why this strategy can excel during a time when interest rates are rising is that bond prices will be falling. That means nothing to you, if you plan to hold your bonds to maturity. But it means that every time you have money to reinvest, there are likely to be deeply discounted bonds available for you to buy.

Let’s say you buy a bond at 75 that has 18 months to maturity and pays a 5% coupon. Keep in mind that the 5% is calculated on the par value ($1,000) so this bond pays $50 a year in interest. Here is the simplest way to calculate your return…

Your capital gain on this bond:    $250 ($1,000 – $750)
Your total interest payments:        $75 (3 payments of $25)
Total Return:                43.33% (interest + capital gain / $750)
Annual Return:            28.89% (total return / months to maturity x 12)

In this case, you’re making an annual return of 29%. That’s more than three times the average long-term return of the stock market and it would put you well ahead of all but the worst inflationary scenario.

Bonds are the answer to many of the problems investors have with the stock market. You know exactly how much you’re going to make, exactly when you’re going to be paid, and you get much needed protection from the volatility of stocks. With the strategy Steve McDonald has developed, you get safety and peace of mind, without sacrificing the growth of your money.

Source:  Crustaceans, Currencies, and Conversation in Delray Beach