Talking Points

Bonds

Is it just me, or does it happen to everyone else on the planet as well? I steer my cart toward the shortest line in the grocery store, which invariably moves the slowest. I'm at the bank and it seems as though the person in front of me is both depositing a check and applying for a loan; I turn right when I should have turned left. Somehow, in what is a marvel of modern statistics, whenever I have a 50 / 50 chance at something, I manage to choose incorrectly 90% of the time.

What amounts to a loss of time and minor irritation becomes more so when it pertains to one's financial affairs. Investors, once running scared, no longer hear the growls of the bear fast on their heels. They've started to slow their withdrawals down a little but remain cautious--so an occasional glance over their shoulder to see if anything's still chasing them from time to time seems within reason. The more brave have trickled back into the stock market with great trepidation, but those who have witnessed their savings dwindle are still reluctant to take the plunge. They need to hold on to what remains and are not willing to take on any risk, even a small amount. These investors have been lulled into a sense of security by investing in what is often considered to be the safest investment known to man. They were enticed by the comfort of government bonds - literally the textbook example of a risk-free asset. The U.S. Treasury has never defaulted on its financial obligations, nor does it appear likely to begin doing so anytime in the near future. It is important to remember, however that there are different types of risk--and while, if you purchase a 10-year bond you are receiving the explicit guarantee of the most powerful country in the world that your money will be returned, no one guarantees any more than that.

Reluctant to park their money anywhere they'd be committed to lower returns for that length of time, investors moved toward shorter duration bonds with maturities of three years or less, expecting the equities market to stabilize by that point. Investors are now priding themselves on their new "ultra-safe" assets, and while bonds are as safe as you can get in terms of default risk, bonds are still quite vulnerable to interest rate risk. The 2-year bond that looks so appealing right now at 0.94% won't look so good when the Fed begins to raise interest rates to combat the inflationary measures. As interest rates rise and bond yields subsequently increase, investors so eager to snap up "safe" assets at 0.94% will be forced to sell at a discount to match the yield resulting from freshly issued bonds. Now consider the fact that short term bonds are currently selling at a premium of roughly 4% to as high as 7%, due to eager investors chasing yield, ignorant of the ultimate consequences of their new investment strategy.

Quite simply, the price of a stock is comprised of a myriad of different variables: cash flow, dividend yield, the PE ratio, and many more. The price of government bonds is, for the most part, made up of only one. When interest rates go up, government bond prices go down--something of which we are all aware. Well, maybe not all of us. There are those of us that when presented with a 50 / 50 chance will still pick incorrectly 90% of the time.