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DOMESTIC FIXED INCOME
GETTING A HIGHER REAL RETURN AT LOWER RISK
When people think about investing their “safe” money into CDs, bonds, or other fixed income investments, they need to see the forest for the trees. They need to go beyond merely considering the percentage points of yield and credit quality of fix income investments that are posted on sign boards at their local bank. Too many banks focus only on credit quality and yield, and are derelict about alerting investors to broader market and economic risks.
As evidence of the way in which investors are being kept in the dark, Forbes Magazine columnist James Grant reported the following study in his Aug 11, 2003 article "How to Short T Bonds:"
Bethesda, Md., June 26--A survey conducted by Harris Interactive on
behalf of ProFund Advisors LLC finds that, although most U.S. investors
(57%) believe interest rates will rise in the next two years, nearly
two-thirds (65%) are unaware that rising rates generally have a negative
impact on the value of bond investments.
When I talk about inflation, I mean the cost of every day consumable items. Despite all the talk by the Fed and US Government since the stock market peak in 2000 about “deflation,” the price of most every day consumables has been steadily going up in line with money supply growth. The deflation worries are really about the decline in value of major assets pumped up by the stock, bond, and real estate bubbles that were fueled by easy credit expansion policies in the late 1990s. Jim Rogers wrote an excellent article printed in the summer 2002 issue of Worth Magazine titled “They are Lying to Us Again” (archived at www.jimrogers.com) about how the prices of consumer goods have been steadily going up at a much faster rate than indicated by government statistics. He points out that movie tickets, dry cleaning, and other every day costs were going up about 7% a year in the 1990s.
Market risk poses two threats to your fixed income investments.
First, in the long run rising inflation and rising interest rates typically go hand in hand. Even if you hold your investment to maturity, the real purchasing power of the coupon payments you receive and the inflation-adjusted bond redemption value will likely decline.
Secondly, rising interest rates hurt resale value. If you need to sell your CDs or bonds before maturity, the value of your bonds will go down. As a dramatic example, a 1% increase from 5% to 6% in 30-year interest rates reduces the resale value of a thirty-year bond by about 13.8%. Once interest rates move up, changes in interest rates will not be so dramatic, but will still be significant. A move from 9% to 10% reduces the value of a thirty-year bond with a 5% coupon by 9.4%. Shorter duration bonds and CDs also decline in value, but to a lesser extent. The shorter the maturities, the less sensitive bond resale values are to interest rate swings. The mathematics of bond calculations also work out so that sensitivity to interest rate swings also goes down as coupon rates increase.
Hence, in the current economic environment, weighing market risk is every bit as important as weighing credit risk. An individual who buys a 30-year bond yielding 5% with a triple A credit rating may have eliminated most of his credit risk, but if interest rates were to change from 8% to 10%, he will lose about 18.8% of the market resale value of his bonds. He might end up losing more than a junk bond fund invested in foreign bonds that suffer some major defaults that impair net asset value by 15%. I provide an additional discussion regarding how bonds lose value if interest rates rise near the end of this section.
BEATING THE BANKS ON BOTH YIELD AND RISK MANAGEMENT
Finding a higher yield. I can shop the national market better than many local bank branch operations. I have access to CD, bond, and other fixed income inventories all over the country. As for safety, your investments are custodied by First Clearing Corporation through Sammons Securities Co. LLC, member NASD and SIPC. First Clearing is owned by Wachovia Bank, one of the stronger and more reputable banks in the country. We can set up an interest bearing checking account and debit card to give you immediate access to your funds.
Diversify away forms of market and economic risk. There are a number of approaches that can reduce your exposure to the risk of rising interest rates and the real costs of inflation:
Shorten durations: Mathematically, as fixed income duration gets shortened, the level of market risk decreases significantly. A move in interest rates from 5% to 6% reduces a 30-year bond paying a 5% coupon by 13.8%, but reduces a five-year bond with the same coupon by 4.2%. The ultimate in short durations are money market funds, which typically invest in government debt with maturities less than 180 days.
A major disadvantage in shortening durations is that the real rate of return on the bond yield curve may decline rapidly as maturities are shortened. At various times the real rate of return for short-term instruments, adjusted for inflation and taxes has been negative. That may be a signal to look for other types of investments rather than gamble that interest rates may drop lower and provide a positive real rate of return on the coupon payments and increase the real return on the bond redemption value.
Ladder bond portfolios: This involves arranging bonds in staggered maturities such as two years, four years, six years, and eight years. This leaves a certain portion of the portfolio that can be periodically reinvested, such as every two years. If interest rates go higher, some capital is always available in periodic intervals to capture the higher yields. This approach can help one obtain slightly higher risk-adjusted rates of returns compared to not staggering maturities. As a technique, laddering is analogous to dollar cost averaging in purchasing stocks. It tends to work best in sideways or modestly changing markets.
A major disadvantage of bond laddering is that it is wholly inadequate to deal with markets that are at risk for major changes. It may give clients a false sense of security during the lull before a storm. As an extreme example, laddered portfolios in Argentina in the late 1990s prior to Argentina’s hyperinflation got crushed almost as badly as unladdered long bond portfolios.
Floating rate funds: These funds typically provide revolving credit to businesses. They offer yields which typically float a certain percentage above a benchmark such as the discount rate or LIBOR (London Interbank Offering Rate). The advantage is that if interest rates rise, the investor receives a rising yield that helps to maintain the market resale value of his underlying investment.
Some disadvantages are as follows: In the short run, short term interest rates can be manipulated and suppressed relative to real inflation by the Fed and other central banks. (C.f. My discussion of central bank manipulation in my paper “Amidst Bullish Hoopla: A Behind the Curtain Look at Fed Desperation and Intervention Wizardry”). The discount rate and other benchmark indices may significantly lag real inflation. Also, in a stagflationary environment that combines inflation and economic stagnation, there is often a rise in business bankruptcies. Higher default rates can reduce the net asset value of a floating rate fund. This can completely offsets the gains made by earning interest rates above money market rates. As an example, in the mid-1990’s various floating rate funds had default rates which created write-offs of less than .5% while earning interest roughly 2% higher than money market funds, for a net 1.5% gain. Then in the 2001-2002 period one fund in particular charged off 2% of its NAV due to a higher default rate. The floating rate funds typically provide revolving credit to businesses that are not large enough to raise capital through bond issues. The credit quality is usually in the borderline investment grade zone barely above junk bonds. Therefore, they are vulnerable to any serious recession.
Preferred stock that pays a dividend based on units of a precious metal. Historically, gold and silver have been considered the ultimate form of money and an ultimate hedge against inflation. This is particularly true if we take a perspective of hundreds, if not thousands of years. There is strong evidence that we are now in the end game of central bank wars that have been waged against gold of the 20th century. Central banks have been fighting gold on and off ever since they went off the gold standard to help finance World War I and later fund social welfare states. Fed Chairman Alan Greenspan provided additional details in his famous article “Gold and Economic Freedom” that he wrote in 1966 while a member of libertarian Ayn Rand’s inner circle, although paradoxically since he became Fed Chairman he has done more to undermine gold than almost any other leader in high finance. After a campaign of suppression in the 1960’s and early 1970’s, central banks removed the lid just enough to allow gold to take off during the stagflationary 1970’s. There is strong evidence that a suppression campaign returned in the 1990s. But now, as discussed in my “Amidst Bullish Hoopla” paper, it looks like the Fed and other central banks are beginning to lose their grip once again.
As a caveat, please be aware that a disadvantage of getting involved with precious metals is the extent to which metals markets might still be manipulated. Currently on the COMEX exchanges the short positions on gold and silver are multiples of the quantities available for delivery. Even to this day the International Monetary Fund prohibits its members or borrowing countries from linking their currencies to gold. In addition, gold has a dual nature as a commodity as well as a form of money, and often commodity prices can be volatile.
Foreign bonds. . This pertains to bonds denominated in foreign currencies that are likely to remain credit worthy and retain their value, and whose currencies are likely to remain stronger than the dollar. Many foreign bond funds have performed very well for my clients in the last two years, and I expect them to continue to do well. The underlying value of their principal and the value of their interest payments have both gone up as the dollar as gone down. The advantage of foreign bond funds is that they can continue to benefit if the dollar continues to slide. Many foreign countries with relatively sound currencies offer higher yields. Their central banks have not made such a strenuous effort as the Fed to artificially suppress interest rates.
A disadvantage of holding foreign bond funds is the possibility that US Government and Fed intervention can temporarily override long-term market forces. For example, from 1995 to 2000, Secretary of the Treasury Robert Rubin pursued a strong dollar policy that artificially increased the value of the dollar against other currencies and hurt foreign bond funds. This occurred despite deteriorating fundamentals for the dollar based on the growing balance of trade deficits and rapid monetary expansion. However, since 2000 it appears that the US Treasury and the Fed have lost the will and ability to push in the opposite of market fundamentals. They now appear to be fighting a delaying action to help slow the decline of the dollar. As long as the US continues to run massive balance of trade deficits and the money supply ramps at over 7% a year, I expect that the dollar will continue its long term slide and foreign bond funds will continue to do well. Of course no market trend is perfectly continuous. One can expect a longterm bear trend to be periodically punctuated with bullish countertrend rallies before resuming their downward slide.
Inverse interest rate fund: This type of fund is designed to go up in value if interest rates rise. It shorts 30-year bonds, so its chart looks like the inverse of a 30-year bond chart. James Grant provides an overview in his article “How to Short T Bonds,” Forbes, August 11, 2003.
The disadvantages of an inverse interest rate fund can be two fold. First, interest rate movements can be a two-edged sword. If long-term interest rates continue to go down, one loses money. Secondly, short funds have to pay the interest income on the bonds they short to the party they borrow from. Hence, in order to make money, the gains from a rise in interest rates have to offset the interest earned on the underlying bond short positions.
Three topics are discussed below:
How inflation and government intervention
can impact on interest rate trends:
Let us imagine that we have an economy that runs on laissez faire free market principles and has a stable currency. The main things we would focus on would credit quality and the yield curve.
Now let us imagine that the government introduces rising inflation. This inflation is introduced in a very simplistic way, in which the government creates more money, and makes no effort to hide this fact or disguise its impact on the market. In this environment, in addition to looking at credit quality and yield, we would now also need to watch money supply charts like a hawk. Acceleration in money supply growth means inflation will start popping up within some lag time, such as one to two years. Rising inflation means eventually rising interest rates.
Bond investment strategy in an environment of rising inflation, rising interest rates, and a depreciating dollar against other currencies is fairly simple: bail out of your domestic fixed income! Get into commodity-like investments whose prices tend to rise with inflation or get into foreign bonds whose currencies are likely to retain their value. Wait for evidence that the government is genuinely committed to start bringing inflation back under control. Then look for bonds with healthy real rates of return and jump back in.
What makes bond investing vastly more difficult than using the aforementioned approaches are the tremendous interventionist powers of the Federal Government and Federal Reserve that grew mightily in the 20th century. Both entities have the power to take the kinds of free market relationships that I have just mentioned and turn them on their heads. To add to this confusion, in the latter part of the 20th century, laissez faire economic theory was generally relegated to gathering dust in the back stacks of libraries and “top down” interventionist viewpoints such as Keynesianism, Monetarism, and “Supply Side” economics became dominant. The latter viewpoints throw some rhetorical bones to laissez faire economics here and there as window dressing, but for the most part they justify activism and intervention by a big government and a big central bank. They rationalize and promote economic policies that would have been considered irresponsible “exceptions to the rule” back in the early and mid-1800’s.
Basically, one must do two levels of analysis. First, do the classical economic analysis. This is always important because in the very long run, markets are stronger than government intervention. Second, watch the government and Fed very closely and try to figure out their real agenda. If the agenda goes against classical economics, which happens quite often, it is usually the better part of valor to stand back for one to five years or however long it takes for the government and Fed to do their thing, and then reenter once the smoke clears and free market sanity returns. In fact, the “snap back” period can often provide a good investment opportunity.
For readers interested in a specific example of what I am talking about, a good starting point is the way in which the Fed has muscled down and suppressed the price of gold in the late 1990s until it reached a final bottom in 2001. The Fed has been gradually removing the lid since then and gold has been steadily rising. The Fed has also muscled down the Federal Funds rate with 13 consecutive rate cuts since Jan 2001 to 1% by June 25,, 2003, the lowest rate in 45 years. I discuss the levers of power it has used in my lengthy paper about Fed desperation and intervention wizardry. The major media and major Wall Street firms have supported the Fed’s spin program that “deflation” is the big issue, despite the facts documented by Jim Rogers in “They Are Lying to Us Again” at www.jimrogers.com. I believe that the Fed is really worried about stock, bond, and real estate market asset price deflation from the bubbles it has helped create and not so concerned about consumer price inflation, which has been steadily growing. Given the serious fundamental economic problems addressed in the Grandfather Economic Report, if anything, rather than having 13 rate cuts and declining interest rates, in a genuine free market economy interest rates would have likely gone sideways or upwards.
A rising interest rate example: This provides a concrete example regarding how rising interest rates hurt a bondholder.
Imagine an investor buys a bond for a certain fixed amount, lets say $1,000, with the expectation that he will receive interest payments at a certain percentage rate (lets say 6% or $60 a year), and will then get the initial investment principal back at the maturity date, of, lets say, 10 years.
This means that a person can hold the bond for 10 years, collect $60 a year, and then get $1,000 back at the end the time period, regardless of whether interests rates go up or down.
Let’s say that five years into this program, the investor decides he needs more cash than his coupon payments and wants to sell the bond. Imagine that interest rates have gone up from 6% to 10%. Now look at this bond from the viewpoint of a prospective buyer. On the open market, he could pay $1,000 to buy a bond that matures in five years and get a 10% rate of return on his initial investment on the coupon or $100 a year. If the seller offers a buyer a bond that pays only $60 a year, that obviously would not be worth as much as one that pays $100 a year. To make his bond attractive, the owner of the 6% bond must offer a discount off the $1,000. If the offering price is dropped to, lets say, $845 instead of $1,000, and the buyer gets the $60 a month payments and the $1,000 back at the end of five years, the mathematics (internal rate of return) work out to where he can make the same rate of return as the 10% rate he can get on the open market. The 4 percent increase in interest rates caused the bond owner to lose about 15% of the value of his bond with a maturity date five years out.
Imagine that the same bond holder had held a thirty year $1,000 bond that paid a 6% coupon, or $60 a year, and let us say that interest rates jumped 4% within a month and he decided that he wanted to get rid of the bond right away. In this case, the bond would now be worth $621, dropping 38%. A bond that is six times longer in duration than the previous example (30 years vs. 5 years) would drop about 2.5 times in value.
This helps to explain peculiar periods involving rapid interest rate moves in which bonds have been more volatile than stocks. One example took place in 1994 when interest rates made a 4% upward move, and the bond market actually had a bigger loss than the stock market. Another important point is that under certain types of market and economic conditions, rather than offering a diversification advantage, bonds and stocks can go down together. This happened during the stagflationary 1970’s, when rising interest rates caused bond prices to fall as the overvalued stock market from the 1960’s era also declined due to P/E multiple contractions. I think that a similar situation lies ahead over the next five to ten years.
Appearances can be deceiving regarding banks
and their conflicts of interest
Serious problems keep popping up in the American banking industry. I mention in my “Amidst Bullish Hoopla” paper that JP Morgan Chase has unregulated derivatives exposure estimated to be over $25 trillion. This could potentially serve as a detonator for the total unregulated derivatives market which now stands somewhere above $130 trillion. Major money center banks still have not solved their continuing crisis exposure to unpayable third world debt. After destroying in the 1990’s the 1930’s era Glass-Stieglel Act prohibitions against consolidating banking across state lines and engaging in the securities business, many banks are now a part of the $1.4 billion securities industry settlement in early 2003 for allegedly misleading investors. Also please consider the banks that got caught in the S&L Crisis in the late 1980’s that cost taxpayers over $160 billion. We can go back further to all the banks that sold elderly clients low single digit fixed income investments in the early 1970’s before the double digit inflation of the late 1970’s brutally swept in and destroyed much of the real value of their savings. Please also consider the huge spreads between what banks pay in savings accounts today (below 5%) and what they make on credit cards (above 20%). Amazing how credit card interest rates failed to come down with the thirteen consecutive Fed rate cuts since Jan 2001 that brought the Fed funds rate down to a 45 year low of 1% on June 25, 2003. Many banks have not only been indulging on spreads that under certain state laws in another era would have been considered usury, but they have also been aggressively marketing more credit cards to the public along with home equity refinancings at a time of record national indebtedness.
As discussed in the “Why Better” section, I operate as an independent “cyber broker” unencumbered by corporate quotas, special privilege-related conflicts of interest, and the overhead of bricks and mortar. Most bank branches are quite the opposite, with almost nothing spared in the way of appearances to add legitimacy to their fixed income and other investment-related sales, ranging from big signs outside branch offices to massive vault doors inside. And of course let’s not forget the cookies, coffee, balloons, and tellers’ smiles. However, one might want to look beyond the props and wonder about the extent to which many banks are compromised by their close association with the problematic areas of the American banking system.
CBOE 30 Year Treasury Yield Index (TYX),
graph for last ten years
Flag carried by the 3rd Maryland Regiment at the Battle of Cowpens, S. Carolina, 1781
Text and web design by William Fox. Sometimes
William Fox offers viewpoints that are not necessarily his own to provide