Friday, September 24, 2010

The Bubble In Bonds Part 3 - Other "Bond-Like" Instruments

This is Part 3 of a 3-part series about bonds.  In Part 1 of this series, we discussed that while bonds are generally believed to be "safe", they some bonds may actually lose 40%+ of their value in a rising in a rising interest rate environment - and from our current historically low interest rates, interest rates have no where to go but up.  In Part 2 we discussed some ways to invest more safely in bonds so that when interest rates rise and the current bond bubble bursts, you are not faced with worse losses than in the 2008-2009 stock market decline.  In Part 3 we will talk about some bond-like investments that you might consider in addition to or instead of bonds.

Other Bond-Like Instruments To Consider

Some investors that are looking at bonds because they are "safe" are probably barking up the wrong tree.  These investors really want principal protection - which you can't really get with bonds.  You can minimize your principal exposure by lowering the term, but there is still some risk.

For these investors, why not go with a CD?  A CD is "bond-like" in the sense that it pays periodic interest.  However, it has absolute principal protection, unlike bonds. According to Bankrate, you can get a two-year CD at 1.75% and a 5-year CD at about 2.75%.  That very much beats out the one-year treasury at 0.25% or the 5-year treasury at 1.4%.  Further, although the 30-year treasury is at 3.87%, that comes with a huge risk to principal.  Think about it - you can lock in 2.75% with no risk, or go for one point higher with the risk of losing 40% of your principal.  To an investor looking for preservation of principal (which is really most of those looking for a "safe" investment) the answer is clear.

Comparing CDs to munis, the percentage return on the munis is even greater (after taxes), but the default risks for munis that don't exist for treasuries are very scary.  Comparing CDs to corporate bonds, you would certainly have some principal exposure with a corporate bond, but there are high-quality corporate bonds available.

Another bond-like instrument to consider would be high-dividend paying stocks.  For example, Altria pays 6.5% and Kraft pays 3.7%.  These are solid, blue-chip companies that have a good chance of growing in value in the next few years - unlike bonds, which can only stay the same or decrease because interest rates can't get any lower.  Utility companies are also good - ConEd pays 5% - and it most likely has even greater principal-protecting power than Kraft.

Another bond-like instrument that I have been very happy with over the last year are MLPs - Master Limited Partnerships.  These are kind of like utility companies for oil and gas.  They typically own the pipelines and charge per unit transported rather than based on the cost of oil, for example.  The yields are good and they have mostly gone up over the last year.  For example, ETP yields 7.5%, EEP is at 7.8%, and LINE is at 8.3%.  These are bond-like in that they make periodic payments, but they don't have any principal protection beyond the strength of the underlying business.  However, as the economy continues to recover, the demand for oil and gas should increase and these should thus have a solid base.  Comparing MLPs to 30-year treasuries, I think that you have much more risk in 30-year treasuries due to the impact of rising interest rates - and you have a much higher yield with MLPs.

In summary, for people looking for bonds for principal protection, with interest rates as low as they are now you aren't going to get it.  If you need principal protection, think CD.  Alternatively, for people looking for bond-like instruments with principal protection greater than that of the 30-year treasury and much higher yield, think high-dividend utility stock, diversified blue chips, and MLPs.

(I'm not sure that I need to do this, but I figure I should disclose that I own CDs, bonds (although a far lesser percentage than I used to and no new dollars are going to bonds - and I am out of munis) and most of the stocks and MLPs identified above - in addition to others not identified.  I also reserve the right to buy or sell without telling you, although I currently don't have any sales planned.)

Update: A reader sent me a link to this video which I think has some insights into the bond market and discusses areas of risk and the potential bond bubble - plus it has one of my personal heros - Burton Malkiel in it (albeit briefly).  This also gives me my first opportunity to try to embed video on TheLegalDollar - here goes!  The video is from Newsy.

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  1. I would add that Reward Checking Accounts also offer bond-like interest rates (currently 3% is pretty commonly available nationwide) with FDIC protection, but there are usually hoops to jump through (e.g., 10 debit card transactions per month, direct deposit). Sometimes there's a cap amount of your balance that will get the high interest rate (e.g., 10k or 25k). A listing of many such accounts is available at

  2. Thanks anonymous - sorry for the delay in getting your comment posted, Google flagged it as spam. You are certainly right that some checking accounts are offering rewards interest that is pretty high - often with multiple hoops.

    Here in Chicago, MBFinancial is offering 4% on balances up to 10K if you jump through their hoops.