How to Double Your Gains with Half the Risk

The market just capped off a six week rally. Almost no sector was left behind. Commodities, banks, technology…everything is up. Even shares of embattled commercial real estate companies have started to rebound.

The wild market swings have most investors just as wary as when the market was setting new lows. After six weeks of steady upswings, there still aren’t too many believers in this rally. The mainstream media echoes investor sentiment.

BusinessWeek questions “Is the rally on strong footing?”

Canada’s Globe and Mail advises, “Don’t get your hopes; it’s a dead cat bounce.”

The Financial Times reports Duncan Neiderauer, CEO of NYSE Euronext, said:

“The real money investors are still waiting. I think they’re waiting, they’re watching. They want to make sure that what we saw in March is real.”

On top of that, the mixed signals from economic data shows we’re not completely out of the woods yet. Retail sales fell more than expected this week. Meanwhile, consumer confidence readings rose.

With so much bullish and bearish data and comments thrown at us every day, it’s tough to make a choice. But that doesn’t mean there’s no opportunity. There is. And it’s not necessarily in stocks.

You can find an opportunity in a security which, at currently depressed levels, offers just as much upside potential as stocks and carries significantly less risk than as well. And for investors who move in now, they will be able to ride the current upswing without risking too big of a risk.

I’m talking about bonds.

Follow the Money

Since stock prices fell off a cliff, bonds have become fashionable again. The combination of high yields, low volatility, and a perceived sense of safety has brought investors back into “boring old bonds” in a big way.

Bond returns have been just as good (even better in many cases) than stocks since the markets set new lows last fall and again in March. For instance, the iBoxx Investment Grade Corporate Bond ETF (NYSE:LQD) has rebounded more than 20% from its October lows. It yields about 6%.

The return on more speculative high yield bonds has been even better. The iBoxx High Yield Corporate Bond ETF (NYSE:HYG) has climbed 25% in since early March. It yields almost 12%. As you can see in the chart below, high yield bonds consistently outpaced stocks:

The rally in bonds has been a strong one. And the force driving it is a bit more apparent. The bond rally has been driven by the big money. The big money, like mutual funds and institutional investors, has been buying bonds steadily throughout this downturn and shows no signs of slowing down. That’s because retail investors are continuing to fuel the big money’s buying spree.

A few weeks ago in when we looked into “When Will This Rally End?” we identified where retail investors are putting their money. In the chart below, you’ll see they’ve been pulling money out of stock funds and putting new money into bond funds during periods of relative calm:

This is good news for bonds. Recent data from the Investment Company Institute reveals demand for bonds hasn’t slowed.

Last week, more than $11 billion of new money flowed into mutual funds. Of that money, about $3.8 billion flowed into stock funds, $6.6 billion went to bond funds, and the rest went into hybrid funds which invest in both bonds and stocks.

Clearly bonds are attracting attention once again. Once you take into account the lack of faith in the rally and how cheap bonds have been, it’s not much of a surprise. They offer a lot of potential at current levels.

Double the Return, Half the Risk

For years bonds were written off. A long bull market in stocks attracted a lot of investors to stocks. The rallying cry of Wall Street was, “Bonds are safe and safety is for losers.” When the credit crunch hit though, safety was cool again.

Back in December we looked at the emerging opportunity in bonds. In “Bonds Haven’t been this Cheap since 1932” we looked at why bonds were bonds offering safety, a high yield, and plenty of upside potential:

When the economy is rolling along, credit is flowing freely, and anyone can get a loan at a pretty good rate. In this case the risks might be lower, but the rewards are much, much lower. The risk/reward situation is against you.

During rough times, the risk/reward situation gets flipped around. When no one else is willing to lend (which is basically what buying bonds is like), you can get paid a much higher interest rate. There are a lot of borrowers, not many lenders, and you can get a very high reward (much higher interest rates) for your risk.

That’s what is going on with the bond market right now. The risks are a good bit higher, but the rewards are much, much higher than usual…

From here, either high-grade corporate bonds are absurdly cheap or the world economy, as we know it, is coming to an end.

The financial world as we know it has changed but it didn’t come to an end. And now, despite many well-documented economic problems, they’re still on the rise. And when bonds are rising they offer two ways to make money from them.

The first way is from the interest payments. The vast majority of corporate bonds offer interest payments of anywhere between 5% and 15% depending on credit quality of the issuer.

The second way is from capital appreciation. This return only comes from when bond prices fall.

Take a bond which is issued at $1,000 two years ago which yielded 10%, or $100 a year. The price of it may have fallen to $800 when the credit crunch hit. It still pays $100 a year in interest which works to a yield of 12.5%.

The higher yield will attract some new investors because of the greater return. But you get more than just the $100 interest payment from the bond. The price of the bond also goes up with the bond market. So the total potential gains on a bond like this $100 a year in interest as well as $200, or 25%, in capital appreciation.

That’s a pretty good return for a stock. But it’s a great return for a bond. Once you add that most bonds are safer and, as a while, are less volatile, you’ve got a very attractive opportunity. That’s why investors have been moving back into bonds in a big way. But it’s not like bonds are without risk, but there’s any easy way to unload that.

Taking What the Market Gives You

The big risk with bonds comes in their liquidity. Most are not easy to buy and sell for individual investors. As a result, if the market for bonds turns down, other buyers for the bonds could disappear in short notice. This is what happened during the credit crunch when bond prices plummeted to 70 or 80 cents on the dollar for investment grade bonds.

That’s why, when it comes to bonds, you’ve got to be liquid. The easiest way to do that is with an ETF or closed-end fund. This way you get instantaneously diversified as well.

So with another week of volatility ahead (bank “stress test” results come out next week – in order to be credible at least one bank will have to perform poorly) bonds could be a safe haven which offers income and some decent upside potential as well.

The rally in bonds also shows us there are other worthy investments aside from common stocks. And successful investors will always find the opportunities which offer the best returns relative to risk. At the Prosperity Dispatch, we’re true believers in taking what the market gives you. Right now, it’s giving us an opportunity in bonds.

By Andrew Mickey

About Q1 Publishing 172 Articles

Q1 Publishing is an independent financial research and advisory firm. It is committed to providing investors with well-researched, level-headed, no-nonsense, analysis and investment advice that will help investors secure enduring wealth and independence.

Q1’s mission is to cut through the noise and focus on what really matters. As part of the mission Q1 Research Team regularly publishes analysis and commentary on the most important information investors need to know about.

There are no biases, no hidden interests, just focused on the facts and what they mean for the weeks and months ahead. You can ensure regular updates on the latest economic developments and unique investment ideas in their 100% free e-letter, the Prosperity Dispatch.

Visit: Q1 Publishing

Be the first to comment

Leave a Reply

Your email address will not be published.