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How the Bond Markets React 11.07.05
A Hard Case
Currently, the case against fixed income has been strong. Even with the 10-year Treasury yielding around 4.66% and Greenspan's conundrum somewhat answered as a result, long term is not the investment it appears to be.
If you will remember, Alan Greenspan, the soon-to-be-retired Federal Reserve Chief, was concerned that long term interest rates should be rising in tandem with his short term adjustments to the overnight rate. Only recently, have they started to inch higher on continued selling - a bonds yield rises as selling pressure pushes the price down. But those yields are still not high enough.
At least high enough to warrant investing in them and the reason is at the heart of the Fed's steady rate moves: inflation. Currently, the Consumer Price Index is 4.7%, which, against the yield of the 10-year Treasury offers a negative return. Adjusted for inflation, you are not earning anything for your efforts.
This negative yield curve stands out even more when you consider the return on short term securities. For instance, according to the latest data available at BankRate.com, a one year certificate of deposit will net you around 4.59%. When the investor is asked to take on long term risk when the short term provides the same relative yield for the risk, the Fed worries.
And it should. Every time an investor looks to long term securities, they face several obstacles. Aside from interest rate risks, there are credit risks. Credit risks in US Treasuries are considered low even with the ever increasing deficits. The good faith and credit of the government is still attracting investors from overseas. That could change but that's another story.
What investors in fixed income securities should concern themselves with is the reinvestment risk. Right now, there is no compelling argument for investing in fixed income securities with a long term horizon.
The reinvestment risk is based on the volatile interest rate environment. Sure, the Fed has made a steady, almost predictable moves. The questions that arise most is how long will it continue? Will the incoming Fed chief, Ben S. Bernanke change the policies currently in place?
If you are holding bonds in a portfolio, you can expect that the losses to principal will continue. Each time the interest rates increase, the losses on the longest term bonds, which according to Morningstar's survey of long term bond portfolios average around 12 years, increase. Even with annualized returns on over 8% over the last several years, a loss of principal of 1.2% in the third quarter stings.
Intermediate term portfolios have lost less but the rising rate environment still makes a strong case against further investing in anything but short term risk.
The investor does have options. Moving long term money into short term securities is one. Floating rate bonds tied to adjustable rate mortgages, a risk that requires a close monitoring of the mortgage interest rate, have netted the savvy investor an average of 7.2%. A word of caution: In the next eighteen months, over $1 trillion in ARMs are slated to be reset and of those newly adjusted mortgages, almost half are being held by subprime borrowers.
Foreign bonds are a seemingly enticing play but caution is the word. Europe has not been raising their short term interest rates, much to the dismay of Greenspan, which has the effect of offsetting a lock-step type environment.
TIPS or Treasury Inflation Protected Securities offer some protection in an inflation prone marketplace but beware. TIPS are vulnerable to rising interest rates because many bond funds investing in them tend to be long term holdings.
High yield junk may seem attractive as well. Should the lure of junk be too much, make sure that the quality of it is the best available against the risk involved.
We are in for an economic slowdown, the possibility of a bear market on both bonds and equities, rising gold prices as some investors loss faith in the strength of the dollar, and the uncertainty of what Mr. Bernanke might do with the Fed he inherits. All of which makes a compelling argument for diversification.
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