Five years after the start of the Great Recession, many investors are still afraid of the stock market. As of May 28, more than $2.59 trillion sat in "safe" money investments like cash, bonds and treasuries, according to a report by the Investment Company Institute.
The problem with short-term securities is obvious. An investment in a 1-year Treasury bill that's paying 0.1% would take roughly 720 years to double. Even if it were paying 2%, it would take more than three decades just to double your money.
Now, of course, doubling your money isn't the goal with treasuries. The idea most investors have in mind when they park their money in treasuries is to put it somewhere safe, at least until a better investment opportunity comes along. But many investors still want to get paid to wait, as they rightfully should.
So, in an effort to earn higher yields, many turn to another supposedly "safe" investment... One that could quickly turn out to be a "portfolio killer."
That portfolio killer is long-term bond funds. You see, as investors search for higher yields with "safe" investments like treasuries and bonds, they often end up putting their money into mutual funds and exchange-traded funds that hold bonds with longer durations. And as I'll explain in a moment, we think this could prove to be a grave error.
Interest rates are near zero right now with no place to go but up. As the Federal Reserve gradually raises interest rates (inevitably sometime in the future), bond prices will correspondingly fall in value as investors dump them and look for higher-yielding alternatives.
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Our resident income expert, Amy Calistri, warned her Daily Paycheck subscribers about the risk of investing in long-term bond funds last year:
Here's what that means. Let's say you invested in a long-term bond fund such as the iShares Barclays 20+ Year Treasury Bond ETF (NYSE: TLT) which pays an attractive 3% dividend yield right now. Because it holds long-term bonds, it carries a relatively-high duration of 17.
If the Fed decided to raise interest rates by 100 basis points (100 basis points equals 1%) in a year's time, that long-term bond fund could fall 17% in value. If the Fed raised interest rates by 200 basis points in a year, that long-term bond fund could lose as much as 34% in value in a single year.
While no one knows exactly when the Fed will start raising interest rates, it's not unheard of to see a 200 basis point rise in a year's time. The Fed raised interest rates by 200 basis points from 1% to 3% between June 2004 and June 2005 to curb inflation, and raised them another 200 basis points the following year.
And if the possibility of a 34% loss in a single year isn't bad enough, then consider this... Even the speculation that interest rates could rise can send long-term bond funds falling.
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Consider what happened last August, when speculation was mounting that interest rates could start rising. Amy told subscribers of her premium newsletter, The Daily Paycheck, back in August:
As you can see from Amy's chart, all types of bond funds can be hurt from even the possibility of rising interest rates, but the long-term bond fund that held 20+ year treasury bonds was really hammered,plummeting nearly 12% in a matter of four months. And remember, that's without the Fed actually taking action to raise interest rates -- this was solely the work of speculation.
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The bottom line is this -- right now, interest rates have nowhere to go but up from here. Whether or not they rise in the near future, it's clear that funds and ETFs that hold long-term bonds (bonds set to mature in 5 years, 10 years from now or longer) can present a high degree of risk in exchange for mediocre yields.
So if long-term bonds are risky and short-term bonds give us a pittance in exchange for our hard-earned dollars, then where are income investors to turn?
In this article, I show you a much better class of income-producing investments than long-term bond funds. They're not only higher-yielding and much more liquid than bonds or bond funds, they also have an extremely high probability of increasing your income stream each and every year. (Hint: They're not annuities or anything "tricky.")