Ryan Fitzwater: Welcome to Market Wake-Up Call. I’m your host, Ryan Fitzwater, and today I’m subbing in so Steve doesn’t have to interview himself. Steve, welcome to the show. Steve McDonald: Thank you, Ryan. It’s always a pleasure. Ryan Fitzwater: So since the election, the stock market has been on a wild ride. What is going on in the bond market? Steve McDonald: Bonds ideally never do anything. I always say that in my alerts to my bond readers. You don’t want an exciting bond market. Although when the bond market was going up from about March through October of 2016, it had quite a ride. We saw some bonds move up from the teens – meaning they were priced around 17, 25, in that area – all the way up to par, which is 100, and that’s a heck of a move in six or nine months. But since the election, we’ve been seeing some movement in oil-related bonds, some upward movement. We see four and five points a week in some of them. But bonds for the most part since the election have been very stable, which is what I like, as I said. I don’t like a lot of excitement in bonds. Stability is what they’re all about. That’s why people like to own them. So I guess overall we’ve just been holding our own or seeing a few individual companies moving up with the good news out of the oil markets. Ryan Fitzwater: Now you and Marc often discuss the dangers of holding bond funds in this current environment, especially with the projected interest rates rising in the future. Can you explain your rationale for dumping bond funds at this moment? Steve McDonald: I don’t like most bond funds in any market, not just this market. I’ll tell you why, but in this market in particular it’s even more important not to own them ’cause we’re going to be seeing interest rate increases. Janet Yellen came out and said, “We’re probably going to see another one in the near term at the next meeting.” Which I’ve been predicting. I think we’re going to see actually two to three, maybe four, interest rate increases over the next 12 months, but I don’t like them. It all comes back to the idea of greed. People go shopping for a bond mutual fund, they look for yield. If they got the market average yield over the last couple of years since we’ve been sitting at a zero interest rate market, nobody would have put money into a bond mutual fund ’cause you’d be earning 2%, 3% from a corporate bond fund. The way they get people to put their money into these things is they leverage their holdings. They borrow money against their holdings and they buy more bonds. So it looks like you’re getting a higher yield. They also hold very long-maturity bonds because they also pay higher yields, but they also fluctuate more in an increasing interest rate environment. So when interest rates go up, and they’re going to, the cost of your leverage goes up. The value of your long-maturity bonds drops like a rock and you got a double whammy there... the variable rate interest on the leverage increases as interest rates increase and you have dropping bond value, so you’ve got increasing expenses and a dropping net asset value, or the value of the underlying bonds. So what happens is people buy these bond funds thinking that these are safe investments because bonds are typically safer than stocks. But as these two sides of pressure start to build up, prices start dropping like a rock. People start selling their shares in these bond mutual funds and they panic because they don’t understand what they really own and that’s a third pressure that adds on. So now you’ve got increasing expenses. You’ve got decreasing bond prices. And people are selling their shares, which means the manager has to liquidate bonds to fund the liquidations to send the cash out to people who want their money out, and they’re selling into dropping prices. It’s a triple whammy. You don’t want to be in them. I don’t think mutual funds were ever designed to hold bonds. They work very well with stocks. I’ve never seen one work out long term. I know. I’ve been banging the table about this for a long time. I hope people listen because this is not where you want to be right now. Ryan Fitzwater: So then how would you recommend approaching bonds, if at all, in this environment? Steve McDonald: Well, as I said, in any environment I like people to hold short maturities with many small positions. One of the things people get in trouble with with bonds is they – let’s say you have $100,000. You call a broker and you say, “I want to own corporate bonds.”  He’s going to split those up over maybe five different bonds. You’re going to have $20,000 per bond. Ballpark. Some guys might do $10,000 and get 10 positions. My point with my people about small positions has always been you don’t want to have enough money at risk in anything in $10,000 to $20,000 increments. I like to see people buy five bonds or less. Now, people will tell you you can’t do that. A lot of brokers you’ll call will say, “I can only buy you 10. I can only buy you 20.” It’s not true. All you’ve got to do is ask for the bond desk. They’ll put you through and you’re going to be able to buy as few as you like, but I like small positions. I like them at discounts if you can get them. That’s going to be hard in this market ’cause the bond market’s been going straight up for about six to nine months now, but there are still some discounts. I think the last two bonds I bought were at a discount. That way when they mature, you actually make more money than what you paid for them. So you’ve got your yield to maturity. You can get a capital gain on them if you buy them at a discount, but I also like to spread bonds out in such a way that you’re only buying out to about a seven-year maturity ’cause as I said the same pressure that affects bond mutual funds will affect your individual bonds. So you want to buy bonds with a seven-year maturity or less because that’s the range where they fluctuate the least when interest rates go up. So you want to buy small positions. You want to buy discounts when you can and you want to limit those maturities. That’s going to keep your portfolio value from fluctuating. You do those three things, you’re in pretty good shape. It’s not going to prevent all losses. Companies still get in trouble once in a while. Very seldomly. The long-term default rate for rated companies is about 6%. So 94% of the time you earn your money exactly as promised, but what you need to do, and these three things that I recommend you do, limit your fluctuations. That limits panic-selling. Keeps you in your bonds, which is where you’re going to make your money. Let me add one thing. Not all bond funds are bad. Alex Green has a bond fund in his Gone Fishin’ Portfolio. That’s a good fund. They have reasonable maturities and very little leveraging. I don’t think you’re ever going to find a bond fund that has no leveraging, but as long as you keep those two under control, you’re in good shape. Small positions. Discounts when you can. Watch that leveraging in those bond funds if you hold them, too. Ryan Fitzwater: Well that’s great, Steve. I think everyone can walk away with the idea that you have a lot more control with bonds as an individual investor than you would going with a bond fund. Steve McDonald: Well said, Ryan. Very well said. That’s it exactly. When you buy a bond fund, you give up all control. When you buy your individual bonds, you can control the quality, the maturity, the price, and you can also control your emotions by keeping the pressures under control. It’s really important. It’s a head game. I’ve always said that, but it’s a head game that works. Ryan Fitzwater: Well, Steve, thanks for coming on and telling us what’s going on with the bond market and your current approach. Once again, thanks for letting me host and interview you. Steve McDonald: It’s always my pleasure, Ryan. Thank you. Ryan Fitzwater: Thank you all for joining us on Market Wake-Up Call. We’ll see you next time. [End of Audio]