Part III: Barbells, Ladders and Avoiding Bondage

By Andrew Gordon

When your whole world is falling apart, there are always government bonds. Not that the world is falling apart. But neither does it seem to be holding together very well.

Today it’s tattered. Tomorrow maybe it falls apart.

We really haven’t seen anything yet. Stocks are 10-15 percent off their highs. That’s all. And many sectors have been holding up quite well, like energy, agriculture, rails, and commodities.

But moving forward, we can’t have everything go our way. For example, if inflation is to slow down, energy, food, and commodity prices will have to start getting lower. But that means most of the few remaining robust sectors will begin fading along with the greater economy. And the stock market will have lost its last leaders.

And if they don’t? Then we’re stuck with inflation and slow economic growth otherwise known as the dreaded stagflation.

Choose your poison: Continued high prices or equities that will be pushed much lower than where they are right now. In other words, stagflation or a worsening bear market. 

As my charming colleague Lynn Carpenter pointed out in last week’s article , even the safe haven of dividend stocks isn’t a slam dunk anymore. You have to look before you invest, especially among financials.

If you’re thinking safety first – and returns a distant second – there’s really only one place to go.

U.S. Government Bonds may be boring. They may give underwhelming returns. But at least they’re safe. And they do have the full backing of the U.S. Government. And that still means something. Even my esteemed colleague, Rusty McDougal, would have to concede that point.

The biggest challenge in buying bonds?  Locking in at an attractive interest rate. When you buy a government bond, you’re loaning the government money. The longer the government keeps your money, the higher the interest rate it needs to offer you.

If you were negotiating, you’d say something like, “If you want my money for two years, you’ll need to pay me 1.8 percent interest. But if you want it for 10 years, you’ll have to pay me 3.5 percent interest.

This is what actually happens, except the government gets the message not from words but from the actions of millions of people buying and selling government bonds every day.

The risk you’re taking with these government bonds isn’t that they’ll go bad. It’s that inflation will eat away at your earnings. If you’re making 3.5 percent interest on a bond investment, but inflation is going up at the rate of 4 percent, for all practical purposes you’re losing money.

That’s not a good way to save, is it?

Consumer prices are climbing at a 4.1 percent clip right now. But if investors believe these numbers badly underestimate the true rate of inflation, as I do, then they should begin to do more selling than buying of bonds.

This is the self-regulating mechanism of the market. As investors sell, the price of bonds goes down – just as selling pressure pushes the price of stocks down.

And as bond prices go down, their yields go up. As yields rise and become more attractive, it once again draws buyers into the bond market.

“Bond interest rates (not the original yield but the “yield to maturity”) are constantly moving up and down in response to this buying and selling. When you buy a bond, it’s hard to be sure whether the interest rate you’re getting will be better or worse than next year or the year after.

Once you buy the bond, your interest on that bond (the original yield) is locked at that rate. 

However, the price of your bond will fluctuate – as rates move up and down.” And if you’re not sure, then you should not put all your eggs in one basket.

Diversifying your bond portfolio is just as important as diversifying your stock portfolio. But instead of diversifying by sector, you diversify by time.

There are two good ways to do this. You could ladder your bonds. Or you could barbell them. Let’s look at laddering first.

Building a bond ladder is easy. The objective is to be in a position to reinvest your bond returns every couple of years.

Let’s say you have $50,000. Through your broker you could buy a series of 10-year notes. The first series mature in 2009. You buy $10,000 worth. The second series mature in 2011. You put down another $10,000. The third matures in 2013, the fourth in 2015, and the fifth in 2017. You put $10,000 in each.

And what do you do with the money you get when you redeem the note maturing in 2009? You invest it in a bond maturing in 2019. And so on.

That means when interest rates are going up, you’re in a position to buy.
When they’re going down, you’re also buying. For some people, that sounds very safe. For others, it may sound a little crazy...

Why invest in bonds maturing in 2019 if you’re getting a less attractive rate than, say, for 2017? Why not wait? But rates for bonds maturing in 2020, or 2022, or 2025 could continue to head down. You may be waiting a long time for nothing.

And if they reverse and head up? Well, you’ll be in a position to capture those higher rates as you move up the ladder (in years). Then in 2011 you could reinvest the money from your maturing bonds into bonds that are maturing in 2021. And so on.

Laddering is a very safe way to spread the interest rate risk you get with bonds. And, by now, you should know my position on this. I’d rather have you laddering with Australian bonds – or other overseas bonds with attractive rates denominated in strong currencies – than U.S. bonds.

Laddering overseas bonds serves a double purpose. You’re not only spreading interest rate risk, you’re also spreading foreign exchange risk.

A simpler way to play interest rate risk is by barbelling. With that same $50,000, instead of splitting it five ways, you’re splitting it in half. Let’s say you think the yields on 10-year notes will be going up (of course, you can’t be sure). You invest $25,000 in the 10-years. The other $25,000 you invest in short-term notes (maturing in, say, 18-36 months).

At the end of the 18-36 months, you can revisit the 10-year notes. If the yields are more to your liking, you invest. If not, you have the option of reinvesting the $25,000 again in short-term notes, and waiting another year or two to see where the 10-year rates are.

Right now, a lot of people think that U.S. 10-year Government Note yields will be going up, because these bonds are sensitive to the rate of inflation. And inflation is becoming a more serious threat. But if you have money you’d like to invest in bonds right now and you can’t wait, then barbelling may be a sensible strategy for you.

With risk spreading into unexpected places, like municipal bonds, bond auctions, and even the money market, government bonds are one of the truly safe havens left to invest in.

And remember, you can employ these techniques just as effectively with overseas bonds as you could do with U.S. bonds.

Good Trading,

Andrew Gordon

P.S.  To let me know what you thought of today's article, send an e-mail to: feedback@investorsdailyedge.com.

[Ed. Note: With a bear market looming, it’s more important than ever to select safe investments that produce monthly dividend income. Click here to learn about Andy Gordon's INCOME service that selects the best dividend-paying stocks available.]

Market Watch

Med and Caffeine Fixes on Every Corner?

By Andrew Gordon

I ripped into the Wall Street Journal last week in my blog. In a front-page article, it decried the “downside” of hospitals popping up all over the country at a time when our factories are slowly but surely disappearing. The main problem with this? It results in an economy overly dependent on Medicare and Medicaid, according to the Journal article.

In my blog I said that misses the main point. Factories make things. They add to the material wealth of the country. Hospitals don’t. You visit a hospital. You get better (or you don’t). The GDP goes up by $50,000 to $150,000, which is nice for politicians to point to. But the economy doesn’t have anything tangible to show for it.

True, hospitals are hard assets. But you need to understand this important fact: Operators that invest their own cash in hospital real estate never generate revenue from the investment. The hospital gets nothing out of owning it. No rental fee. No usage fee. They make money from using that space to offer additional services...

But, at a fraction of the cost, they could have rented out that empty building on Main Street and offer those same additional services. Hospitals are the very definition of a non-earning asset.

But now I’m having second thoughts. If hospitals are just so much deadweight on the economy, then what about other entities that cater to health? What about spas? They’re like new-age hospitals, aren’t they? If we’re including spas, then are hotels that much different? And aren’t hotels just big restaurants with beds?

Really, it comes down to the fact that hospitals are in the service industry. Should we condemn them for that? At least they try to improve or prolong valuable earning assets ... namely, us. Doesn’t that count for something?

I think I owe the Wall Street Journal an apology. Hospitals popping up all over the country are no better or worse than Starbucks appearing on every other corner. Starbucks already had their run when they made investors a ton of money. It’s hospitals’ turn now.

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