This Important Advice Might Save You Thousands Of Dollars

Subscribers send me dozens of questions and comments every month. While I can’t always address each one individually, I do read them all.

One question we income investors are asking ourselves right now is “Should I own bonds?”

The answer is yes, but for reasons I’m about to explain, you will need to be cautious.

After all, major stock market averages are soaring, with both the S&P 500 and the Dow surpassing all-time closing highs set back in October 2007.

The bull run in stocks is also flying in the face of continued uncertainty about interest rates staying low if a divided Federal Reserve starts to phase out its $85 billion-a-month bond-buying program — not to mention trouble in Japan and already high valuations for many dividend-paying stocks. So that leaves one question: Why do many analysts still think equities will keep grinding higher?

Whether the bull run will stay its course remains to be seen.

Yes, investors are coming off the sidelines and pouring record amounts of cash into long-term mutual funds. Stock funds are attracting record flows as well. But intermediate-term bond funds are also attracting above-average inflows.

Companies are still sitting on record amounts of cash. Default rates on corporate bonds — even for companies with questionable credit that pay high yields — are low. And it will take some time for any unwinding of the Fed‘s various easing and stimulus programs to go into full effect.

But there is a danger lurking in the bond market. And you need to be aware of it. It’s a danger that only comes up when there’s a perfect mix of low interest rates, cash-rich companies and yield-starved investors.

It happens when investors get caught up in the euphoria and end up buying a bond that is trading well above par. (Par value is the face value of the note at which companies typically buy them back from investors.) And while that might be OK in some markets — in this market, it can be downright dangerous.

Let me give you an example.

Back in February 2009, I bought US Cellular 7.5% Senior Notes. At the time — the height of the downturn — they traded at just over $17 each, despite having a par value of $25.

While the market was scared, there was an opportunity. In the roughly two years I held the bonds, they each paid $1.88 in annual dividends (for an effective yield of 10.7%) and the price soared back above the $25 value, padding the returns even more.

All told, High-Yield Investing subscribers who bought and sold with me ended up making more than 69%… on a bond… in a little more than two years.

So what’s the problem?

A few weeks after I told readers to sell, these notes were called early. Now, imagine if an investor had waited to buy those bonds until they traded above par value — only to see them get called shortly thereafter.

Those who bought the notes above the par value not only lost a solid income stream — they were also hit with a capital loss.

If you had invested $50,000 into these notes at $26 (just $1 above par value), you would own 1,923 notes after the transaction. But since US Cellular called them, the company would pay you just $25 per note (par value), and you would have only been given $48,075 back for your notes — a $2,000 loss on your original investment.

This particular situation happened two years ago. But I’m still seeing this “call” trend happening. With interest rates still near record-low levels, companies are taking the opportunity to call bonds early and refinance at lower rates by issuing new bonds at lower yields.

This is why investors thinking about buying bonds, preferred stock and other callable securities need to be careful. It’s getting more common for these securities to be called back, leading to a huge potential loss if you paid more than par.

But these investments are still worth owning. Their above-average yields should continue to provide superior income while staying immune from all but an extremely sharp and rapid rise in interest rates.

While some of my more recent additions like Hercules Technology’s 7.00% Notes (NYSE: HTGY) are now trading above par, we will continue holding bonds and looking for new bond ideas in High-Yield Investing.

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