I hate to toot my own horn. But if you will recall, I warned about our economy falling off a cliff very early on. See my past blog posts. They say hindsite is 20/20, and we can all look back now at the housing bubble and think, "I should have known this was coming." Of course, we are all trying to recognize trends early so that we can position our clients before things get too ugly. When I shine up my crystal ball, here is what I see happening in the future.
If you have been to my workshops recently or listened to my radio program, you know that one of the issues we have been discussing is safety. Bonds are often touted as a safe alternative to stocks. Recent articles and evidence have suggested that bonds are safer than stocks over the long haul. However, bonds carry a substantial amount of risk, and in my humble opinion, should not be discussed as safe. If you can lose money due to market volatility, then it is not safe.
Bonds, as we all know, have several different risks: default risk, credit risk, and call risk to name a few. I am going to discuss what I believe is the most obvious risk of all right now -- interest rate and term/maturity risk. Most people know that bonds have a direct relationship with interest rates. If you buy a bond today and it is paying an interest rate of 4%, and tomorrow interest rates go up, and I can now buy a bond at 5%, I could potentially lose money if I had to liquidate my bond before maturity.
Why would anyone want to buy a 4% bond from me when they can buy a bond from the issuer at 5%. Well the answer is they won't want to buy your bond at 4% unless you discount the price. If you hold a bond today and interest rates go up, your bond would be worth less money if you had to sell you bond before maturity.
The question to ask yourself right this very second is, "Are interest rates gonig to stay flat, go down or go up in the future?" Take a look at a historical chart of the feds fund rate at the link below before answering this question. We are printing money, interest rates are at a historical all time low, and we are starting to see less demand at our treasury auctions, which are causing interest rates to rise. Right now this is all pretty subtle. Even though there is plenty of media coverage, it seems like people aren't paying attention.
In the early 1970's, the stock market crashed. The Dow Jones Industrial Average (DJIA) fell 45%. That's a doozie. Prior to the crash, the federal funds rate was at 12%. The federal funds rate is one way our government influences short term interest rates and encourages economic growth. By lowering the rate they allow for cheaper borrowing, which in turn should stimulate the economy.
Well by 1976, the federal funds rate had plunged from 12% to less than 6%. Why is this important? Well think about how people react after they lose 45% in a stock market sell off. They go to their Broker and say Mr. Broker I want more safety. So the broker follows the common wisdom that bonds are safer than stocks, and so he rebalances the client portfolio and puts more money in bonds and less in stocks.
But remember that by 1981 the federal funds rate had skyrocketed to 18%. So even though you were buying bonds for more safety in 1976, you were buying in at 6% or less. A few years later, you could buy bonds that were paying 18% or more. If you had to liquidate your 6% bond before maturity, you would have taken a great big bath. And if you didnt liquidate the bond, you saw all of your friends earning 3 times the yield. Painting the picture that bonds are not as safe as you might think.
Fast forward to 2007. The federal funds rate in 2007 was 4% before the market crashed and now it floats from 0% to 0.25%. People are going to their broker and saying I want more safety... you can see where this is going. The broker rebalances their portfolio to a stronger bond position and ... well the future has yet to happen, but folks if I were a betting man, I'd have to bet that interest rates are going to be higher in the future. Remember if interest rates go up and you hold a bond, the value of your bond is likely to go down. And you could recognize a loss if you had to liquidate that bond before maturity.
One of the primary reasons I believe interest rates are going to go up is because of the continued lack of interest in the treasury offerings. Lets face it. We need foreign nations to finance all of the spending we are doing. These countries are not very excited about buying a 30 year treasury bond that is paying 4% especially when our dollar is down the tubes and losing ground as we continue to print money. The solution will have to be higher interest rates to continue to attract capital from our foreign financiers.
So what can you do about it? If you are looking for more safety, you must use safe money alternatives. I define safe as something that is guaranteed, and you can always calculate your worst case scenario if you have to liquidate before maturity regardless of what interest rates are doing.
We can use bonds as a negatively correlated asset class to stocks to offset your portfolio for your at-risk and market sensitive investments, but bonds are not the safest place for your money to be either. And always remember to ask about the term of the bond. If you are retired and are 70 years old. Do you really want to buy a 20 year bond? And don't fool yourself about the strength of the company you are investing in. Things change. What you may perceive as a strong company today may not look to good in just a few years. Just look at Chrysler, Lehman Brothers, Enron, GM, Worldcom, Bear Stearns, Washington Mutual.
Here is the bottom line. Should you own bonds in a well diversified at-risk investment portfolio?
Answer = Yes.
Just remember that you can lose money in bonds so they should be used with caution and should be considered an at-risk investment rather than a safe one.
With my clients one of the first questions I like to ask is, "How much money do you want safe and how much do you want at-risk?" Bonds fall into the at-risk category, and we use alternative fixed income investments that provide guarantees and safety for the money our clients want safe.
PS -- Below are a few link that you should probably review if you want more insight into how I am formulating my opinions:
Jason Parker is the President of Parker Financial LLC, a fee based registered investment advisory firm specializing in wealth management for retirees. His office is located at 9057 Washington Ave NW #104 in old town Silverdale, WA 98383. He holds the series 65 securities license as well as being licensed to offer life and health insurance in Washington State. For more information please contact Jason at 360-337-2701 or online at http://www.parker-financial.net/. The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. The opinions and information presented do not constitute a solicitation for the purchase or sale of any securities or insurance products. All information is believed to be from reliable sources; however, we make no representation as to its completeness or accuracy. The publisher is not engaged in rendering legal, accounting, mortgage or other professional services. If other expert assistance is needed, the reader is advised to engage the services of a competent professional. Please consult your Financial Advisor for further information.
0 comments:
Post a Comment