I have referred several times to a spreadsheet I built over the last couple of years. It begins with bond yield and inflation data from 1946 to 2010. Bond yield data is taken from the Moody's Seasoned BAA yield series. It represents "average" yields, by year, for corporate bonds of good, but not prime quality. These bonds have a very low default rate, yet yield considerably more than the very top investment groups (AAA, AA and A). Their rates have varied a great deal over the years, going from lows of 3.21% to 16%. A key factor is that these rates are usually higher than the prime rate (the rate charged "prime" customers for short-term borrowing) for any given year, and usually beat inflation. Why are the seasoned BAA rates higher than other bonds? It's very simple: they are long-term rates. As the website says: "Moody's tries to include bonds with remaining maturities as close as possible to 30 years."
Why are long-term rates so much higher? They reflect a perception of risk. The farther out a maturity is, the more things can go wrong. Rates can rise, eroding the value of the bonds. Inflation will also do its erosion. Finally, there is credit risk: the possibility that the financial health of the issuing company will deteriorate to the point that the bond defaults. All of these possibilities lead investors to expect, and demand, higher rates of return for long-term bonds. There is also a perceptual problem most investors have with these bonds: thirty years is "too long". Older folks think they'll die first; younger ones dislike thinking about how they'll look in the mirror in thirty years. Either way, that endless prospect discourages investors.
I believe, though, that BAA type bonds represent the absolute sweet spot in the investing world. Sure, if you're old, you may be dead before these bonds mature. But in the meantime, you'll be collecting those fat interest payments. And will your spouse, children, or grandchildren, refuse the money? Furthermore, if you need cash in the meantime, there is a ready resale market for most large-cap bond issues. The price you get on a resale may vary greatly, depending on present interest rates (either up or down), supply and demand, and the ever-present fear factor. All these make it a very good idea to make your initial bond purchases at a discount to par. That shields you on the downside, and builds a predictable upside into the transaction (if you hold the bond to maturity). It will, after all, return the exact same amount as the original buyer paid upon issuance (par).
My ideal scenario, reflected in my spreadsheet, is to build a long-term bond portfolio steadily, year after year. A predictable amount should be added to the portfolio regularly, and interest income should be reinvested steadily. This latter requirement means that the bonds should be held in a tax-deferred vehicle like a traditional IRA, Roth IRA or 401 K plan. Since taxes are paid on the latter two only upon withdrawal, and the Roth is funded with post-tax money, everything compounds tax-free. That's huge, as you will see.
Why not wait for those magic moments when bonds have reached a cyclical peak, and then pounce? Well, there are two problems with that. First, those moments of peak yields are also moments of extreme terror. In 1982, and 2009, people were running AWAY from bonds, not towards them. In 1982 they were panicked about rates (16% and higher) exploding upward. In 2009 they feared the entire financial universe was about to crash. Second, it's hard to recognize a peak until it's past. Once it's past, you regret missing it, and stew instead of acting. The brave souls who grabbed for peak and near-peak yields were richly rewarded, but they spent many sleepless nights until things went their way. I was one of them, because I was following a plan (albeit a newly conceived one).
Psychologically speaking, brave investing is a non-starter for the huge majority of investors. Fear overwhelms greed at the precise wrong moment. It's easy to be intrepid when you've just reached new highs in your portfolio; it's exceptionally difficult to jump in when you've just taken ferocious losses. So, how can you overcome your own inner demons? The only way I know is to have that plan, and stick with it through thick and thin. Put it on autopilot as much as possible.
My next blog will demonstrate the results of following a plan.
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