Beating Buffett

Rates at generational lows and volatility at decade plus highs makes for an extremely risky place to be sitting.

Many yield-hungry investors have shifted to medium and long-term bonds- both treasuries and junk, to try to earn more than the pittance offered on bank deposits and money market funds. They are likely to get whipsawed again as yields have already started rising and bond values are slipping.

Chart source: Bespoke Investment Group

The investment public has been throwing more money into bonds and bond mutual funds than ever before in history. Fear of our poor economy further depressing stock prices has prompted this move out of equities and into fixed income. Rather than focusing on the merits (or lack thereof) of locking in generational low coupon rates let’s examine the nuts and bolts structure of open-end mutual funds – the type that has attracted most of the new inflows.

PIMCO, the world’s largest bond manager, was just on CNBC touting bonds as “the place to be”. No conflict of interest there, right?

For ease of understanding I’m going to use exaggerated interest rate movements in this explanation to illustrate the problems with the typical bond fund. Note: This does not apply to closed-end bond funds which have a fixed amount of money to manage and trade on a supply and demand basis like stocks do.

Our theoretical example;

Mutual fund holders of ABC are happy with their 10% current yield and feel sure that they will benefit if interest rates decline because “bond values go up when interest rates move down”.

They were correct in their prediction that long –term rates would drop as by June 30^th the new 20-year Treasury issue was at 5%. You’d think that the original investors would be doing great in that environment.

What probably happened, though, was something like this…

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With 2 straight months of lessened Chinese ownership of U.S. Treasuries the day of reckoning is getting closer for these ‘risk-free’ securities.

It’s a topsy-turvy world right now with short-term interest rates near zero and even the 5 and 10-year treasuries are paying peanuts. As of July 16, 2010 the 5-year note was yielding 1.7576% and the 10-year note was paying 2.9955%.

 That’s pre-tax. Take away even 30% for combined federal and state taxes and the 5-year comes to 1.23% with the 10-year at 2.10%. Nobody I know believes their own cost of living has been flat to down as the government reports. Take away even 2.5% per year for inflation and both the 5 and 10-year bonds become clear losers in terms of buying power preservation on an after-tax and inflation-adjusted basis.

So what’s a person to do? Defy conventional logic and ‘Buy stocks for income’.

14 of the 30 DJIA stocks now yield an average of 4.18% - well more than the 10-Year Treasury’s 2.9955% fixed-rate return.

 If you lock in that T-bond rate today the best you can hope for is to capture that < 3% interest rate and get your [inflation ravaged] principal back at face value.

> $100,000 in 5-year bonds will produce just $1,767.50 in annual income right now.          

> $100,000 in 10-year bonds will produce just $2,995.50 in annual income right now.              

> $100,000 equally divided among the 14 listed stocks would provide $4,180 in yearly income at today’s dividend rates.

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