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Markets: Bond Blues
New York: March 03, 2008
By John R. Stephenson

Who wins the race — the tortoise or the hare? In the world of investing, bonds have often been pitched as the slow but steady tortoise — solid, slow, but great for chopping portfolio risk (volatility) while, at the same time, cranking out solid investment returns. Stocks, on the other hand, are the investment equivalent of the hare. Fast out of the block, but a little bit variable in terms of performance. For many investors, stocks are for studs and bonds are for wimps!

But over the last twenty years, the wimpy bond investor has had the last laugh. That's because bond investors have enjoyed what has amounted to a near perfect storm of high returns and low risk, thanks to interest rates that have been on a steady path downward (bonds rise in value as interest rates drop) over the last two decades.

For American bond investors, the gold standard by which all other bonds are judged is U.S. government bonds. They are the benchmark (since the risk of default is considered to be zero) against which all other bonds are priced and valued — if they sink in value, then so too, will corporate and municipal bonds. But why should bond investors worry, isn't the Fed lowering rates and aren't bonds on the rise?

Figure 1: Declining Interest Rates Have Been a Boondoggle for Bond Investors!

(U.S. 10-year Government Yields)

Source: Bloomberg

For now it is smooth sailing, but can the good times continue? It's doubtful. For starters, interest rates are artificially low right now, as central banks around the world grapple with the specter of a U.S. housing slowdown that has led to a banking crisis and now a global credit hiccup. Today, job one for central bankers is to stave off a recession. But once the coast is clear on the recession front, central bankers will return to their traditional role as inflation fighters.

And inflation is everywhere! Everything, from gasoline to food, is up — way up in price. While some modest inflation is positive for the economy, the inflation that we are experiencing globally is strong. The same people who have brought us $100 oil are also bringing us $9 Wheat and $5 corn — namely, the emerging economies of India and China.

But couldn't interest rates continue to fall? It's certainly possible, but highly unlikely. And the direction on interest rates is pretty much the whole shooting match when it comes to bond valuations. With interest rates at 3.65% on the ten-year U.S. government bond, it's hard to see interest rates going much lower.

And zero is as low as they can get! Why? Well, would you be willing to lend the government $100 to get back $99 a year later? Forget it! It would be simpler and easier to store that $100 for a year, under your mattress or in a safety deposit box, rather than locking in a guaranteed loss.

Certainly, interest rates have been lower than they are today. For example, during the Great Depression, the interest rate on some U.S. Treasury debt fell to as low as 2 basis points (that's 0.02%). But, it's hard to see rates heading there anytime soon.

Adding to the upward pressure on interest rates is a huge U.S. debt burden. With deficit financing the norm, a war in Iraq and a slowing economy, America has a projected (2011) cumulative U.S. Debt/GDP ratio of 74%. While the highest-ever Debt/GDP was 122% (in 1946), rising American indebtedness is a big worry for bond investors.

The reason? Like anyone who abuses their credit, creditors may eventually demand higher compensation (increased interest rates) to lend. Another risk? You get your dollars back but they buy less than they originally did. While U.S. inflation certainly is a worry, another worry is the possibility that an overly indebted government might resort to the printing press to make good on their IOUs. While unlikely, there is historical precedent of various governments around the globe turning on the presses to honor their IOUs, while at the same time debasing their currencies.

With interest rates poised to go up, rather than down, an investment in bonds is looking increasingly like a suckers bet. So what's a savvy investor to do if rates are indeed on the rise?

For starters, borrow at fixed rates. Rising interest rates will tank your family finances, if your borrowing costs start to rise. If interest rates fall instead of rise, you can always refinance at lower rates.

If you must hold bonds, do so only for short durations. That's because, as a bondholder you are actually acting as a lender. The shorter the term of your loan, the less risk you'll face from changes in interest rates. As well, borrowing less is another savvy strategy to keep you out of the doghouse if rates turn skyward.

Stocks may be in for a rough ride as inflation rears its ugly head and sends economies and stock markets rushing for cover. Your investment strategy should be to invest in commodity producing companies whose products are demanded around the globe and are a beneficiary of rising inflation rather than a victim of it. By limiting your exposure to bonds, investors are taking concrete steps to avoid a nasty case of the bond market blues.

StephensonFiles is a division of Stephenson & Company Inc. an investment research and asset management firm which publishes research reports and commentary from time to time on securities and trends in the marketplace. The opinions and information contained herein are based upon sources which we believe to be reliable, but Stephenson & Company makes no representation as to their timeliness, accuracy or completeness. Mr. Stephenson writes a regular commentary on the markets and individual securities and the opinions expressed in this commentary are his own. This report is not an offer to sell or a solicitation of an offer to buy any security. Nothing in this article constitutes individual investment, legal or tax advice. Investments involve risk and an investor may incur profits and losses. We, our affiliates, and any officer, director or stockholder or any member of their families may have a position in and may from time to time purchase or sell any securities discussed in our articles. At the time of writing this article, Mr. Stephenson may or may not have had an investment position in the securities mentioned in this article
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