One Premium Bond to Protect Your Wealth

Steve McDonald

Investors may think cash is safe, but it's really a losing position. You pay tax on any interest, plus there's inflation. Stocks are risky, but they're not a guaranteed loss.

Imagine buying a property that’s guaranteed to go down 3% to 5% every year. I’m not talking about the drop in the real estate market since the collapse, but a 3% to 5% drop every year, even during the best times in real estate.

To virtually everyone — except maybe IRS auditors — this is insane, but it’s exactly what most people get when they retreat to cash.

The Oxford Club’s Chairman’s Circle

Here’s a real conversation I had last week, on this exact subject, with a couple while I was in Naples, Fla. for meeting.

W

e were waiting for a table at the bar in a restaurant and I struck up a conversation with them. The man and his wife are real estate developers from Atlanta.

This guy told me he made a bundle on his properties by getting out at exactly the right time in 2007. Not a planned exit, rather an opportunity popped up and he jumped on it. The timing just happened to be pure gold.

The bad news is that Bob and his wife have been sitting on a huge amount of cash since then. He’s not sure what to do, but is leaning toward bonds of some type; he likes the safety. She is sure cash is the safest place and she’s not budging.

Bob knows cash is a losing proposition, but can’t get his wife off the fence.

So, I took my best shot at explaining how they might reach a good middle-of-the-road compromise in corporate bonds: my kind of corporate bonds — ultra-short maturities.

But first we had to convince the wife…

Cash is a losing proposition

So, I tried the straight-up approach that cash is a losing proposition in any market. By the time you pay taxes on any interest — if you can call what cash is earning now interest — and inflation takes it bite, you always end up losing.

This article published with permission from InvestmentU.com.

The wife wasn’t budging. “At least we aren’t getting killed in the market!” she said.

“Ok,” I said. “Think about how much you have missed since the bottom of the collapse, even if all you did was play the spy.”

Her response was, “No more stocks, too risky. We’re getting too old to take that kind of risk.”

My next volley, the house example, “How can you justify buying any property that loses money every year: good years and bad?”

She was stumped. How could that happen? That makes no sense. The house example was close enough to home that it registered. Her facial expression changed as the paradigm shift settled in.

I’m pretty sure she’ll never look at cash the same way, again.

I had hit pay dirt; she was listening.

“That’s exactly what’s happening to your cash,” I said. “Depending on your tax bracket, after taxes and inflation, you’re losing about 3% to 5% of the value of your money every year. It’s virtually the same thing as losing money on a property every year.

“How safe does that feel?” I asked.

Investors who run to cash during tough times have the same mental block about the safety of cash, and it’s tough to get them to see the real affect taxes and inflation have on their money.

The problem is that most investors who retreated to cash are there because they won’t or can’t afford the risk of the stock market and don’t know what else to do with their money. Getting them to move anywhere else is a very big deal.

Here’s one play for the “still stunned by the collapse” folks out there that will make a decent return even after taxes and inflation take their share.

Phh (Cusip: 693320af0) has a bond with a 7.125% coupon that’s selling for a little premium at 101.9, $1,019. The annual return on this bond is around 5.09%, and it matures next March 15, 2013.

Normally, I don’t buy premium bonds … but this is the exception.

Remember, we are trying to get shell-shocked folks out of cash and into something safe and with a very short maturity to avoid any fluctuation if rates go up before next March. That puts severe limits on the number of available choices, so we’ll bite the bullet and pay a little bit more for this bond. The bond’s annual return and very short maturity justify it.

A one-year maturity paying 5.09% with a BB- rating is as rare as flexible divorce lawyers. That’s a huge return in this market.

BB-, a little over 5% for less than one year; that’s a great deal in this market.

The ultra-short maturity gives us very limited market exposure — less than a year — and very good protection from a big drop in value if rates move up. That gives us a better bet of being able to get out at break-even if the cash is needed or the jitters return before maturity.

While the shell shocked among us may never be ready to get back into stock investing, this is a way to put some money to work to make something while they’re treading water.

The key to success in this bond market is to limit how much you put into each bond, always keep the maturities ultra short — a five-year average is best — and avoid leveraged bond mutual funds and bonds funds with maturities over five years.

There are alternatives to the cash crash that’s silently robbing most folks, but these alternatives will require some level-headed decision making and realistic expectations. Unfortunately, that rules out a lot of people.

I

f you can stay out of the rate pig category and not jump on the highest yield you can find, you can earn a very respectable return with almost no interest rate risk and virtually none of the risk of the stock market.

Cash is a guaranteed loss. Do something about it.

Steve McDonald is a part of the research team at InvestmentU.com. See more articles by Steve here.