Even hibernating bears know that bonds have essentially been dead money over the last several years. Interest rates are ridiculously low and not likely to improve this year based on Fed comments and the stagnant U.S. economy. What's done is done, so what should we expect to earn from bonds in the future?
Consider these two scenarios:
Best Case Scenario
Interest rates and the price of bonds will remain steady. Although this is the best case scenario, it is quite ugly. Consider the 5/23/2014 Treasury Yields: 1 mo. 0.04%, 3 mo. 0.04%, 6 mo. 0.05%, 1 yr. 0.10%, 2 yr. 0.37%, 3 yr. 0.79%, 5 yr 1.55%, 7 yr 2.09%, 10 yr 2.54%, 20 yr 3.12% and 30 yr 3.40%.
Do you really want to commit your money for five years just to break the 1% threshold, or 20 years to break the 3% threshold. Sure the money is guaranteed by the full faith and trust of the U.S. government, but inflation is eroding your spending power each day money is held at these yields.
Worse Case Scenario
Interest rates will rise at some point in the future, but is that a good thing for income investors holding bonds? The price of a bond has an inverse relationship with interest rates. That is, when interest rates rise, the price of bonds goes down and when interest rates drop, bond prices increase.
With short-term bond interest rates hovering around 0%, it's not difficult to determine the direction of the next major move. If you buy a bond for $100 paying 1% and interest rates move to 3%, the bond's price will have to fall to $33 to provide the market's 3% return ($1/$33 = 3%). Even a modest increase to 1.5% will erode your bond price a third to $66.
These are simple examples. The real price erosion will be heavily influenced by the remaining term of the bond. The longer the term, the more price erosion.
So, what's an income investor to do?
Over the few years, I have reduced my bond allocation and purchased quality blue-chip dividend stocks that are yielding in excess of my bond holdings. Consider these dividend growth stocks that have a current yield equal to or greater than the May 30, 2014, 3.12% yield on 20-year U.S. Treasuries.
McDonald's Corp (MCD) is the largest fast-food restaurant company in the world, with nearly 35,000 restaurants in 119 countries. Yield: 3.2%
The Clorox Company (CLX) is a diversified producer of household cleaning, grocery and specialty food products is also a leading producer of natural personal care products. Yield: 3.3%
Lockheed Martin Corp. (LMT) , the world's largest military weapons manufacturer, is also a significant supplier to NASA and other non-defense government agencies. LMT receives about 93% of its revenues from global defense sales. 3.3%
ConocoPhillips Co. (COP) is one of the largest independent oil and gas exploration and production (E&P) companies in the world, COP spun off its downstream assets in May 2012. Yield: 3.5%
Verizon Communications Inc. (VZ) is the largest U.S. wireless carrier, Verizon also offers wireline and broadband services primarily in the northeastern U.S. Yield: 4.2%
AT&T Inc. (T) provides telephone and broadband service and holds full ownership of AT&T Mobility (formerly Cingular Wireless). Yield: 5.2%
I am not predicting an imminent collapse of bond prices. As an investor (not a trader), I am not in the prediction business. However, I believe we have reached a point where there is much more to lose than gain by holding bonds. Interest rates will eventually rise and those holding bonds, especially long-term bonds, will suffer painful consequences.
Full Disclosure: Long MCD, LMT, COP, T in my Dividend Growth Portfolio and long T in my High-Yield portfolio. See a list of all my dividend growth holdings here.
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