The environment today is kind of depressing if you're searching
for yield. A lot of people are doing crazy things like chasing junk
bonds or shaky currencies, which is fine if you can stomach a lot
of volatility. But what if you're just the average guy or sovereign
pension plan looking for income that you can count on? What do you
do if you're the guy who can tolerate a little bit of risk but also
wants to get the best bang for his buck on that risk?
Today we're going to outline a somewhat controversial strategy
for that. I'll give you a hint: It involves bonds AND dividend
stocks. Think of this as a companion article to our
Trade of the Decade
post of August, where we discussed not just
favorite trade for the next 10 years, but also those of others such
as John Mauldin and Barry Ritholtz. It's fine if you don't want to
, but guys like those two have earned the right to be taken
Right now investors in search of yield are leaning heavily on
the bond market, even with the paltry yields on U.S. Treasuries.
Before we get to the meat of our strategy, we need to begin with a
brief discussion of a really important concept from the bond market
that very few people are paying attention to.
The cruel math of the bond market
Bond math gets a little wonky, but I'm going to keep it
Let's say you go out and buy a brand new 10-year Treasury bond
at auction. It's a new issue, so the coupon rate and yield are the
same, which today would be in the neighborhood of 3 percent. You
are guaranteed that rate of return for the next 10 years, and you
are guaranteed by the government to get every dollar of your
principal back. Pretty cool. Yay 3 percent!
But there's more to the story. Let's say that we get some good
economic data and things settle down and interest rates go back up
a little bit. The 10-year bonds that the Treasury now issues pay
That's cool if you're shopping for bonds -- but it's not cool if
you already own them. The problem is that your bond now pays less
than everybody else's bond: 4% is better than 3%, so the price of
your bond goes down.
And in our simple example, the price of your bond goes down
about 8 percent. The sparkling fresh bond that you paid $10,000 for
is now worth $9,200. Ouch! That might not be a problem if you plan
on hanging onto the bond all the way to maturity, but maybe you
need to sell it because a good opportunity has come along. Maybe
you want to remodel your kitchen. If so, that means you'll take a
That's not a forecast. It's simple mathematics. If you own a
bond and interest rates go up, it means the value of your bond goes
down. I repeat: That's not a forecast or a casual rule of thumb. It
is a law by which every bond must abide.
For the last 30 years interest rates have been steadily going
down, so pretty much everybody has forgotten what it's like to
worry about what happens to bonds when interest rates trend upward.
I'm not one of those people who are shrieking that bonds are in a
bubble, but the mindset is in some way similar to real estate in
2005. Back then, nobody thought that home prices could go down
because ... well, shoot, it had a been a really long time since
that had happened.
(click charts to enlarge)
I don't necessarily think the pattern of the last three decades
will reverse and start trending back upwards. But you can see that
rates are pretty darn low -- and they can only go so low. Sure,
they could fall to 1.5% on the 10-year and flatten out there the
way they did in Japan; I'd say that's the outcome with the highest
So there are probably a few more cups of punch still in the
bowl. But it's getting late and anyone who's still sober can see
that the party is winding down. All the cool people have gone home,
or -- if they're super-cool -- they've gone to the emerging market
Bond investors have had it pretty good since Jimmy Carter was in
office, and it's probably time to move along. The risks in the
future are much tougher to justify, given today's historically low
yields. This is why PIMCO -- the coolest cat on the dance floor and
the self-proclaimed "authority on bonds" -- is aggressively
expanding into equities -- specifically, emerging market
Depending on your horizon and the type of bond you're buying,
bonds can still make a lot of sense. Just about everybody should
always have exposure to bonds at all times.
But there are long-term risks present in the bond market that we
haven't had to worry about in a long time. There are also some
fundamental misperceptions that are floating around. We call
government bonds "risk-free" because there's no risk of default:
You're guaranteed to get your principal back at the end of the
bond's life. But you're
guaranteed to get all your money back a year or two after you buy
And then there's the risk of inflation. $10,000 will buy you
more stuff today than it will 10 years from now, and if the
inflation rate is greater than your bond's yield you're
gonna feel like a loser. Something to think about when you ponder
those skimpy yields. Is 4.17% really enough compensation for a
30-year Treasury? Think about everything that's happened in the
last three decades.
Anyway, there's a lot going on in the bond space right now that
investors are unaware of. Everybody is chasing yield wherever they
can find it. Disappointment is likely the only thing in their
Japan isn't a perfect template of what lies ahead for the United
States. But given the decisions we've made so far and our
cultural/political policy of exchanging short-term, acute pain for
prolonged suffering, I think Japan is as relevant a bit of economic
history for us as any.
Sure, the printing-press-powered inflationary scenario could
materialize instead. But that would be even worse for your bonds
than the Japan-esque long-term deflationary death spiral.
Here's an idea with a better shot at getting you through either
How to play it
The trade is long term and there are two parts.
The first part is to stay long bonds. Do that any way you
choose. Go buy an ETF like TLT (
) if you're feeling aggressive, and if you hail from Gary
Shilling's deflationary camp, go ahead and follow him into the
30-year bond. If you're more risk-averse, check out something
closer to the front end of the yield curve like the 1-3 year
) or the 3-7 year Treasury (
) if you want a little more yield. You're even fine with PIMCO's
own Total Return Fund (PTTAX).
Part two happens when (or preferably shortly before) the bond
party finally does end. Unlike a college fraternity kegger, it'll
be a bit more difficult to identify exactly when the fun stops.
There will be no flashing blue and red lights pulling up outside.
So keep your eyes peeled abroad and don't stay focused on just the
bond market. When we get the next big equity washout -- and don't
worry, we will get at least one washout in the next few years --
that'll be time to sell all your bond funds. Then simply load up on
high-quality, strong-dividend equities. Stuff like Johnson &
), Intel (
), AT&T (T) or Verizon (VZ), Royal Dutch Shell (RDS.A), Coca
Cola (KO), Kraft (KFT), or McDonald's (MCD). You know, the usual
I know that sounds really simple right now. But trust me, this
is a much harder trade to execute properly than you might think. It
requires zigging today while everyone is zagging, and zagging later
on when everybody has decided to zig. Getting long the 30-year
Treasury is a very unpopular trade right now, and I guarantee that
buying equities during the next correction will be equally
unpopular. But aren't the toughest trades usually the best? Isn't
there a reason why we need maxims like "buy when there's blood in
the streets" to steel our resolve and help us pull the trigger?
So there you go. There's a roadmap for the next decade. There's
risk in this strategy, but it's manageable and I believe that the
rewards relative to that level of risk are attractive. I think it's
a way to keep pace with average annual market returns of 4-6% but
without the 50% drawdowns. It's a nice variant on Jeremy Grantham's
macro strategy of "hold cash and wait."
Long INTC, long SHY.
Klarman Hedges on Breitburn Energy and Alliance