B is for Bond, Buzzard, Bernanke

Charlie is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Picture buzzards circling your portfolio.  That vivid image came to me about six months ago as rising bond fund prices and shrinking yields got my serious attention.  Would complacency put me at high risk when Bernanke and his FED changed the game?  Time to flee!

I ought to be largely in Bonds, like 70% or 80%.  My actual exposure, however, is zero.  Fearful?  You bet I am!  If Bond yields were water, we would see investors checking their canteens.  I continue to watch two funds I formerly invested with: one is the Vanguard Total Bond Market ETF (NYSEMKT: BND), and the other is Vanguard's VWESX Long Term Investment Grade fund.  I am looking for clues to the right time to return to either of these funds, and have yet to find any.  VWEX fell off about 4% in the last 6 months, and its SEC yield is about 4%.  So had I been buying that fund I would have gained nothing in the last six months!  BND had about the same results, perhaps a bit worse; it's off about 2% with a yield of 2.4%, and is trading in the middle of its 52 week range ($108.84-$112.71) at $110.93.  The much lauded PIMCO TOTAL RETURN  shows similar numbers, as does American Funds Strategic Income (NYSE: CSP)

Unfortunately, there is no more hope today. If values drop another 4%, which could easily happen, the yield won't even keep you close to whole, so the time is not yet right for me to return.  Meanwhile, Bernanke's FED holds to a course that oppresses Bond yields and props up the prices (he's a massive buyer).  I expect that when the music stops, and he becomes a seller, prices decline, perhaps rapidly, until people like me see it as attractive enough to start returning to the Bond market. The math is as implacable as it is chilling: just start at a share price of $11.00 with 2% yield, assume a sharp increase in yield to 3%--what does the new share price have to get to?  My math says $7.40 near enough. Of course, that won't happen overnight,  and portfolio changes with new bonds at higher rates will provide some defense.  Just imagine this nightmare- Bernanke and the FED start SELLING bonds, yields rise, maybe inflation too, your capital shrinks as prices fall faster than your yields go up.  What can you do then?  Ride it out?  Sell?  You've already lost part of your capital to invest elsewhere.  Fool ratings on a broadly traded Bond Fund iShares Trust Lehman Aggregate Bond (NYSEMKT: AGG) are abysmal, tending to confirm my bias.

One possible defense might be to select closed-end funds like CSP that are now trading at a discount to Net Asset Value (NAV) rather than full NAV.  CSP appears to be in vogue because the NAV discount on CSP has moderated, going from more than a 10% discount to 5%-8% in recent months, indicating that it has been a more popular buy.  CSP invests in mortgage-related securities, which may be good diversification, but is no safe haven today.

Maybe a better move for me would be to go for ULTRASHORT Bond funds like USAA's UUSTX, which has an averaged maturity in its portfolio of bonds of just 1.52 years.  More to the point, UUSTX has a duration of .69, which means you can estimate that for each 1% rise in interest rates, the price should only drop about .69%, a pretty good defense.   Still, its trading at its 52 week high of 10.14, which suggests its popularity as a defensive bond fund just isn't much of a find for my situation.

My best move looks to be stay away so far.  How long can Bernanke and his FED friends keep this up?  Maybe about 4 or 5 years, give or take.  Still, what might I lose in the process?  If I knuckle under and buy, maybe 10% or 20% possibly more on declining bond prices.  But I would get maybe 2% a year on yield, so perhaps I end 4 years of frustration down 2% or 3%.   If I stay clear, I miss out on say 1.5%-2% yield over 4 years, on $1000.00 that's about $20 a year, and a whopping $80 for all 4 years--pitiful.  Not nearly enough to compensate for the risk, and certainly not enough to compensate for the worry or the annoyance factor.

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