With a large decline in the Dow Jones Industrial Average in 2008 – almost 5,000 points shaved off of the Dow – investors have suffered an expensive reminder of the risks associated with stocks.
In normal circumstances, a year like 2008 would trigger a run by equity investors into capital preservation; that infamous “flight to safety” which economists historically love to talk about in bear markets.
Consequently, in abnormal times, the flight to safety to Treasuries bonds may be a bumpy one. More specifically, Treasuries as a safety net could be a latter day Wall Street fairy tale, akin to the ability of leprechauns to locate gold.
Currently, I believe government bonds are significantly overvalued.
Before we open the book on that tale, let’s take a refresher course on Bonds 101. In the financial world, there are two basic forms of capitalization: equity and debt. Corporations raise money (or “equity”) by selling shares of ownership called common stock, and by borrowing money through a variety of instruments, mainly bonds. Companies that issue bonds pay investors for the use of this borrowed capital with interest. Such payments are typically expressed as fixed amounts that are due on specific dates throughout the year, thus explaining the term “fixed income securities”. But only the income is fixed. Market values of all securities including bonds do fluctuate, for various reasons. The interest and payback of the lent money at maturity (last date of term of the loan) is a promise by the issuing organization.
There are many issuers of fixed income securities besides corporations such as states and cities, which issue municipal bonds, but the Colossus among issuers of debt is the Federal Government and its assorted quasi-credit agencies, such as Freddie Mac and Fannie Mae. Subsequently, any debts issued by the Federal Government are considered the safest and most secure of all fixed income securities since they are guaranteed by the full faith and credit of the United States of America.
Buyer Beware…Only If Held to Maturity
Back to Treasuries again, and the big risk in that flight to safety. Let’s say you buy a Treasury that matures in 10 years and it pays a 3% interest rate. If you hang on to the Treasury to maturity you get the interest payments and the value at maturity. If you decide to sell it sometime after you bought the bond but before maturity you only get what someone is willing to pay when buying it from you. This is called interest rate risk.
Example:
$100,000 invested at par in a 30-year Treasury bought a year ago at 3% pays $3000 a year for each of 30 years. At the end in 30 years you get, par value (your $100,000 back). Let’s also say that you decide after buying this bond a year ago that you want to sell. Assume today a new buyer of 30-year Treasuries could get 4% interest, $4000 a year for each of those 30 years. The result? Your 3% Treasury bought a year earlier is earning 25% less interest compared to that Treasury bond bought a year earlier at 4%. Consequently, your Treasury investment bought a year ago will have to trade at a lower price to compete in a higher interest rate environment. In this example, you would receive less than the $100,000 you originally invested if sold today.
It’s a risk, and one to be aware of.
It’s a funny thing about bonds. Investors seem to recognize that it’s important to be properly diversified with all investment classes, and to have your current spending outlays liquid. But when it comes to bonds, investors are inclined to shrug their shoulders and not worry about diversifying among fixed income investments. Actually, the opposite is true: when investing in fixed income securities, you need to be diversified as well, within the different types of fixed income issuers and of varying maturities. This helps to reduce the risk of default and of interest rate risk.
When the Hammer Comes Down
Let me explain. The US Treasury recently issued some short-term debt at 0% percent. That’s right, you were paid nothing to have your money held safe in Treasuries. Recently the longer-term issues by the Federal government have been paying 2-3.5% interest for 10 to 30 year maturities. We’re in historic and dangerously uncharted waters here. These are the lowest yields I’ve ever remember and, I’m pretty sure, the lowest ever.
How did all this come to pass? Like most calamities, most of it was unforeseen. Go back to 2008. After the Lehman Brothers collapse in September, many investors sold off non-safe investments and poured into Treasuries. That stampede into safety, so to speak, triggered the largest short-term rush to buy US Treasuries in history. With that flight to safety, the Fed subsequently added $800 billion to its financial reserves, by some estimates. That’s good and bad news. The $800 billion represents money taken from other competing assets classes like corporate bonds, municipal bonds. Worse, it makes it potentially more difficult for these issuers to raise debt. The good news? This has helped to reduce the interest rate the Feds had to pay on newly issued Treasuries.
Many economists we follow here at WrapManager suggest that we are in the embryonic stages of an ultra-low interest rate and slow growth environment similar to what happened in Japan over the past 10 years. If this is indeed the case, and interest rates stay the same, your longer-term maturities very well could be great investments. Other economists we monitor say that we are in a period of the biggest refinancing ever of America’s debt, albeit at very low rates, which should spur long-term growth. If, as expected, economic growth develops, the government will stop giving away money and be forced to raise interest rates. When and if that happens, the hammer could fall, as you’ll lose your invested amount in bonds, if they’re sold prior to maturity.
So what’s to be done? One of my favorite rules is “do not fight the Fed.” That stems from my belief that when the Fed lowers interest rates, or when the Fed is being accommodative by somehow stimulating the economy, that growth will come back. Conversely, when the Feds raise interest rates and becomes restrictive in policy, economic growth slows.
What I see happening is that, with lower interest rates, the Fed is refinancing and issuing a big portion of the government’s debt at rates below 3.5%. That means we will be servicing the same debt amounts at lower rates with smaller payments. This also gives an opportunity to any debt issuer to do the same. Cities, states, corporations and homeowners that are able to refinance outstanding debt at these low rates should do so, too. Historically, cheaper money has helped the US and global growth and I believe the same will happen again.
Yes, times are very difficult but I do see an opportunity. There is an old Wall Street maxim that you make your best investments in a bear market, only you don’t realize it at the time. So yes, this bear market has reduced your investment portfolio. But a possible outcome of this current market will be lower interest rates, and cheaper oil and food prices (also known as “deflation”). That lower cost to corporations and consumers means potential increases in spending in other areas, which could help lead to an economic rebound.
So I urge you to come to us for help. Let your WrapManager wealth advocate review your investment plan, especially when it comes to your fixed income allocation.
Above all, and as always, make sure your holdings are in tune with your financial goals.
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