A Common Sense Strategy For The Current Market

"We've always done it this way"

That was the explanation my friend Larry gave me three years ago when I asked him about his company's investment strategy.

Larry is a financial advisor for a firm whose name you would probably recognize. His job is to play golf with potential clients, invest their money wisely, and assure them that risks are being taken seriously. Back in 2022, I had a conversation with Larry about his investment approach -- And I was extremely unimpressed.

At the time, Larry was a proponent of "target date funds" -- mutual funds that combined stock and bond investments and adjusted the ratio as customers got closer to retirement age. The idea was to add more bond exposure as clients get older so theoretically there would be less risk.

In 2022, bond yields were near all-time lows. And these target date funds were investing more capital into these bonds for seniors who needed income and couldn't afford to take as much risk.

In my opinion, these funds were horrible investments and were unlikely to protect investors' capital OR give these investors a reasonable amount of income.

When I was discussing the challenges with my friend Larry, all he could come up with was the lame excuse: "We've always done it this way." And three years later, his clients have suffered greatly because Larry was unwilling to use common sense when it came to the strategy that these retirement funds used.

Don't ever let that happen to you!!

Using "conventional wisdom" blindly can be one of the most dangerous decisions you can make with your retirement account -- and in life.

But thinking through the concepts behind "conventional wisdom" can give you a chance to apply traditional concepts when they make sense and avoid the pitfalls when "conventional wisdom" is inappropriate.

Today, I want to explain what was wrong with Larry's investment approach in 2022 and also show you an opportunity that is emerging in our current market that can hand you extra income with a chance to lock in some large capital gains.

The Trouble with Bonds in 2022

Back when I had the conversation with Larry, interest rates were at all-time lows. The Fed had its target rate for banks set near zero percent. And it was clear that interest rates had nowhere to go but UP!

The problem for bond investors is that bond prices move in the opposite direction from interest rates. So, if rates were set to rise, it was very clear that bond prices were set to fall. In other words, bond investors were poised to lose a lot of money.

When you own a bond, you own debt that is issued by whoever is behind the bonds. Many people buy treasury bonds which are backed by the full faith and credit of the United States.

Other investors buy corporate bonds. These bonds must be paid back by companies -- typically large, well-known corporations.

Traditionally, bonds mature at $1,000 per bond. So, if you buy a treasury bond today, you're buying a contract that says the U.S. government will pay you $1,000 on the date the bond matures. The same is true for corporate bonds, and bonds typically have a specific maturity date.

If you buy a bond that matures next year — and the interest rate is 5%, you should be willing to pay about $950 for that bond. This way, when you receive $1,000 in a year, you'll get a 5% return on your $950 invested.

If the interest rate is 10%, you should be willing to pay something closer to $900 for the bond. That way you'll receive a 10% rate of return when your bond matures in a year. So, you can see that when overall interest rates rise, the current price of a bond must drop.

Bonds with longer maturities are more sensitive to interest rate changes. That's because if it takes several years for the bond to mature at $1,000, then you should be willing to pay a lot less so that your interest can accumulate over time until the bond ultimately pays you $1,000 a few years down the road.

Many bonds also pay bi-annual interest payments called "coupons". These coupons add complexity to the math when figuring out what a bond should be worth today. But the basic concept still applies — as interest rates move higher, bond prices drop. And when interest rates pull back, bond prices rise.

Sure enough, as the Fed began to hike interest rates, bond prices tanked. And Larry's clients who owned target date funds were hit hard. Ironically, it was the investors who could least afford losses that took the biggest hit. That's because their portfolios held a larger portion of "safe" bonds.

Treasury bonds are supposed to offer "riskless returns". That's because the U.S. government has the ability to print money and can always "pay back" its debt -- even if printing new currency causes high inflation.

But in a situation where rates were near zero, these bonds offered "returnless risk"! Because long-term bonds that were sensitive to rising interest rates declined in value. And retirees were already getting near zero returns from their bond investments.

Talk about a terrible situation! And all it took was some common sense to understand that rates were exceptionally low and had nowhere to go but up.

This situation was criminal in my opinion and unfortunately, the following bond rout hit vulnerable investors much harder than those who could afford to take risks.

2025: The Year of Redemption for Bonds

Fast forward to 2025 and we have a completely different situation for bond investors. Interest rates had a chance to recover thanks to higher inflation and a Federal Reserve that spent the better part of 2 years hiking rates.

Today, bonds are paying investors attractive yields and market interest rates appear ready to roll lower.

That means if you buy bonds today, you'll be locking in attractive income payments from now until when the bonds mature.

And you also have the potential for these bonds to trade higher as rates start to pull back.

As I look at the bond market today, I do think it’s a good idea to have exposure to Treasury bonds since their prices will move higher.

Of course, you could go ahead and buy Treasury bonds outright. Most brokerages will allow you to do this with no problem.

Another option is to buy the 20+ Year Treasury Bond ETF (TLT).

This fund invests in long-term treasury bonds. TLT has fallen sharply over the last few years as market interest rates have been rising.

At today's lower price, you can expect to receive a yield near 4.2%, and any uptick in long-term interest rates will drive the price of TLT (and your investment) higher.

The key point is that interest rates are likely making a short-term (or medium-term) peak.

So, in today's market, bonds offer a great way for investors to generate income, create more stability, and potentially profit from a rollover in market interest rates.