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Buying Bonds

February 25, 2014

With today’s low interest rates, looking for reasonable yields from fixed income investments is not easy.  Many investment and fund managers and advisors are recommending relatively shorter-term bonds – with maturities up to five years.  I disagree.  I believe that for many situations, longer-term bonds should be purchased.

For discussion purposes, I will use representative corporate rates, but the principles refer equally to tax-free or Treasury bonds.

The reasoning for using terms not exceeding five years is that “rates will soon rise” and 1) you won’t be locked into today’s low rates and 2) there will be less loss in market values as rates increase.

The “locked in” argument is only valid if rates increase and the investor will then buy longer-term bonds when the shorter-term bonds mature.  From my experience, investors that buy shorter-term bonds never switch to longer-term since they always feel they do not want to be locked in while waiting for higher rates.  Further, the loss in market value argument is a spurious claim since most of the people I know that are not traders and buy bonds to hold to maturity.  Accordingly, the fluctuations in market values create meaningless temporary paper entries.

Most of my clients that buy bonds want the stability of the interest payments, either to spend or accumulate, and safety of principal.  By buying the shorter-term bonds, they are giving up cash they could be collecting.  Those that use investment managers end up barely getting what they could with two to three year bank CDs.  How do these shorter-term bonds make any sense?

My suggested alternative is to buy very long-term bonds, say 30 years.  YIKES?  Am I serious?  Yes.  Let’s look at the numbers.  For our discussion, we will assume 30 -ear corporate bonds yield 5.25% while 5-year corporates yield 2.25%.  You can make similar calculations with any current yields.

If you are willing to buy a 5-year bond and get 2.25% but buy the 30-year bond instead, you will receive 3% extra for each of the first five years.  That is 15% extra.  Dividing this 15% by the remaining 25 years comes up with .6% extra per year meaning that you will “earn” 5.85% for each of the remaining 25 years.  I have a question to ask you.  If you decide to buy a 25-year bond when the 5-year bond matures, how likely is it to expect 5.85% for that 25 year period?  You don’t know, but I suggest that you will probably not buy a 25-year bond, but will buy another 5-year bond (continuing to wait for rates to rise).  If rates stay exactly the same, then you will get another 2.25% also instead of the 5.25% you would have locked in with the original 30-year purchase.  This results in another cumulative 15% greater than you would have received.  So, now, you banked 30% additional interest that can be spread out over the remaining 20 years.  That works out to 1.5% extra for years 11 through 30 or 6.75% for that remaining “20 year” bond.  We are getting into an area that would be hard to match unless rates really start shooting up and then all the stars have to be perfectly aligned for you to catch it exactly when your five-year bonds mature and you have the cash to reinvest.

The point I want to make is that those intending to hold bonds until maturity should consider very long-term bonds rather than shorter-term.  There are other issues and I refer you to my next blog for more information.  There are many arguments on every which way of buying bonds – mine is presented here.

Work out the numbers!  Compare the cash flow.  Figure out how you are richer.

3 Comments leave one →
  1. Robert Blum permalink
    February 25, 2014 12:58 pm

    I see your logic Ed. The risk is if inflation spikes, the value of the bond plummets, and the investor is forced to take a loss to achieve a better return. Bond price declines can be very severe.

  2. Robert Nagler permalink
    February 25, 2014 1:22 pm

    Hi Ed With interest rare as low as they are if the rate rate move up the principal
    amount of the bond will go down . I think that since bond re long term investment
    you might not get your principal investment out .

  3. February 26, 2014 9:53 pm

    Mathematically perhaps correct but who is willing to tie him/herself in for 30 years and give up the flexibility? If you are 35 and use to bond to build retirement income you probably better of buying and holding high dividend shares which would benefit from capital appreciation as well and have some sort of inflation hedge. If you are 65 you may not live to see the day to get the return at maturity.
    I would agree with buying individual bonds of solid companies and hold to maturity rather than a bond fund or tracker which would be at risk of value loss as inflation and rates rise.

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