Is there a bond bubble? There’s certainly more froth than not, with investors recklessly reaching for the riskiest of yields.
But there’s one last 10% dividend on the board worthy of our consideration. It’s available thanks to investors’ misunderstanding (and laziness) – we’ll discuss details in a minute.
But first, let’s review three key rules that will help us navigate this budding bond bubble.
Rule #1: Maximize Your Upside
Our favorite second-level thinker Howard Marks noted in an op-ed for Barron’s that Netflix, Inc. (NASDAQ:NFLX) bond buyers – who recently scooped up €1.3 billion of Eurobonds paying just 3.625% – might have exposed themselves to significant downside without much upside.
After all, they bought the bonds rather than the stock. For 3.625% annually.
I’m with Marks – this is a low upside, high downside wager. Investors are forgetting that Netflix had to heroically reinvent itself just five years ago!
Bonds in This Rollercoaster? No Thanks
Apple’s Steve Jobs was fond of “betting the company” regularly on a new product, idea or technology. He believed that’s what it took to stay ahead of competitors.
And Jobs, of course, had a perfect track record on his own double-downs. But it was his shareholders who were richly rewarded – his lenders merely got paid back.
Meanwhile AT&T Inc. (NYSE:T), which is three decades past its own technology pinnacle, just issued one of the largest bond offerings in recent memory. It’s expected to bank $15 billion from desperate yield seekers who will receive between 3% and 5%.
But AT&T’s stock pays a 5% dividend. And while its payout growth is limping along at a penny per share per year, at least there’s some yearly upside.
Still, though, that’s not enough for our income needs.
By now, you probably know my requirement for current income – 6% or better. (I only waive this for total returns of 12% or more annually.)
And 6% current yields are still available today. But most investors lament the S&P’s 1.9% payout and the 10-Year’s 2.4% coupon, because they don’t know where to look. We do, however – and we’ll talk 10% dividends shortly.
Rule #2: Limit Your Downside
Our 6% current yield minimum will assure us of 6% annual returns, provided we don’t lose any capital. This may sound obvious, but we can’t forget it.
A secure no withdrawal portfolio means we never sell shares for income. We may sell a stock or fund and then purchase another one, but we’re not eating our capital to create an income stream.
Contrast this with an annuity, which misleadingly includes return of capital in its “yield.” Or the “4% fallacy” – a notion crafted by hack financial advisors who pulled a safe withdrawal number out of thin air. The theory conveniently overlooks the fact that retirees who follow this advice will sell more shares when prices are low. A recipe for disaster.
Many income hounds share our affinity for 6%, 7% and 8%+ yields. But they reach for them, and forget to limit their downside.
That’s happening today in the closed-end fund (CEF) space. These vehicles were forgotten stepchildren just 18 months ago. But investors are so desperate for yield they’re piling into them – so much so that mainstream rags such as Business Insider are talking about them these days.
And there are plenty of ways to burn capital in CEF-land if you don’t know what you’re doing. Buy a bad fund (there are plenty of them). Or buy a good one at a premium (and overpay).
Here’s a real-life example that you may have already profited from yourself. In April 2016, I compared two bond funds. Both paid big 10%+ yields. Both benefited from a brilliant bond manager at the helm.
In fact, they shared the same manager – Jeffrey Gundlach, the Bond God himself. The man who dethroned Bill Gross as the supreme deity in fixed income!
And both funds shared a “wide mandate” that basically gave Gundlach and his team the go-ahead to buy anything they want. The only difference between the two last April was price per asset owned. The DoubleLine Opportunistic Credit Fund (NYSE:DBL) traded for a 17% premium to its net asset value (NAV), while the DoubleLine Income Solutions Fund (NYSE:DSL) traded for a 7% discount.
In other words, investors were paying $1.17 for just $1 in assets for Gundlach’s first fund – while paying just $0.93 on the dollar for the assets in his second fund. And there didn’t seem to be any good reason for the discrepancy, other than unlucky timing. Here’s what I wrote last April:
Buying DSL today gives us 5-7% upside as investors warm to Gundlach’s second fund. It’s not as popular simply due to unlucky launch timing – from late 2013 through the start of this year, investors fretted about the possibility of higher interest rates. Thanks to these worries, we’re presented with the best opportunity to buy DSL since inception – at a 7% discount, for an 11% yield.
How’d the last 13 months turn out? We enjoyed 33% total returns (including dividends) from our purchase of DSL. Meanwhile, investors who overpaid for DBL saw their money go nowhere.