Best Case ScenarioInterest rates and the price of bonds will remain steady. Although this is the best case scenario, it is quite ugly. Consider the 12/15/2011 Treasury Yields: 1 mo. 0.0%, 3 mo. 0.0%, 6 mo. 0.05%, 1 yr. 0.12%, 2 yr. 0.26%, 3 yr. 0.37%, 5 yr 0.86%, 7 yr 1.38%, 10 yr 1.92%, 20 yr 2.60% and 30 yr 2.92%.
Do you really want to commit your money for seven years just to break the 1% threshold, or 20 years to break the 2% 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 ScenarioInterest 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%, its 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?
Bond AlternativesOver the next several months, I plan to reduce my bond allocation and purchase 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 2.60% yield on 20 Year U.S. Treasuries:
McDonald's Corporation (MCD) | Yield: 2.6%
McDonald's Corporation is the largest fast-food restaurant company in the world, with about 32,900 restaurants in 117 countries.
United Technologies Corp. (UTX) | Yield: 2.7%
United Technologies Corp. portfolio includes Pratt & Whitney jet engines, Sikorsky helicopters, Otis elevators, and Carrier air conditioners, among other products.
Coca-Cola Company (KO) | 2.8%
The Coca-Cola Company is the world's largest soft drink company, and it also has a sizable fruit juice business.
3M Company (MMM) | Yield: 2.8%
3M Co. provides enhanced product functionality in electronics, health care, industrial, consumer, office, telecommunications, safety & security and other markets via coatings, sealants, adhesives, and other chemical additives.
AFLAC Incorporated (AFL) | Yield: 3.0%
Aflac Incorporated provides supplemental health and life insurance in the U.S. and Japan. Products are marketed at work sites and help fill gaps in primary insurance coverage. Approximately 80% of earnings comes from Japan and 20% from the U.S.
General Mills, Inc. (GIS) | Yield: 3.1%
General Mills, Inc. is a major producer of packaged consumer food products, including Big G cereals and Betty Crocker desserts/baking mixes.
Procter & Gamble (PG) | Yield: 3.2%
The Procter & Gamble Company is a leading consumer products company the markets household and personal care products in more than 180 countries.
Johnson & Johnson (JNJ) | Yield: 3.5%
Johnson & Johnson is a leader in the pharmaceutical, medical device and consumer products industries.
ConocoPhillips Co. (COP) | Yield: 3.9%
ConocoPhillips Co. was formed via the 2002 merger of Phillips Petroleum and Conoco, is the fourth largest integrated oil company in the world.
I am not predicting the 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 for those holding bonds, especially long-term bonds, it will have painful implications.
Full Disclosure: Long MCD, UTX, KO, MMM, AFL, PG, JNJ, COP. See a list of all my dividend growth holdings here.
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