This blog is written weekly by Dock David Treece, a registered investment advisor with Treece Investment Advisory Corp. It is meant to share insight of investment professionals, including Dock David and his father, Dock, and brother, Ben, with the public at large. The hope is that the knowledge shared will help individuals to better navigate the investment world.

Wednesday, June 16, 2010

First Real Estate, Next Bonds: The 1-2 Punch

Risk is one of the most ambiguous terms existing in the financial world. Though its commonly accepted definition almost always includes complex mathematics, it has recently been acquiring increasing subjective meanings.

For example, the ‘risk’ inherent in bonds is, in theory, reflected the bond’s yield. If an investor adds up the separate forms of risk found in a given bond, including those risks associated with liquidity, default, reinvestment, inflation, they will supposedly arrive at the bond’s yield to maturity.

However, it is becoming increasingly apparent that investors in fixed-income securities, both corporate and government-issued, have become increasingly lax in considering various forms of associated risks. This failure to recognize risk is nearly identical to what occurred toward the end of the real estate bubble, when investors failed to recognize the possibility of property values declining, mortgages defaulting, etc.

Surveying the market today, there are countless bond issues whose prices hardly justify their investors’ risk exposure. This has led us to the leading us to the ironic conclusion that bonds, typically thought to be among the safest investments, are in fact among the most dangerous to be found in today’s market.

Consider first the risk of default that remains for bonds from both the private and public sectors. Despite the recovery in share prices that has taken place since the stock market bottomed last year, companies are hardly out of the woods. As discussed in previous articles, the economic recovery hardly justifies current high prices, nor do they reflect the difficulties still facing corporations, both in U.S. and abroad.

These difficulties include uncertainty regarding government regulation, credit that has remained tight since the financial crisis, and big businesses encounters continual criticism in the court of public opinion.

The default risk associated with bonds issued by many municipalities and sovereign nations has certainly been increasing as governments have struggled to service mounting debts. This is especially dangerous, as government bonds are typically considered the safest of the safe investments.

However, even if issuers don’t default, fixed income securities still pose a serious threat to investors’ portfolios.

As we have written several times before, interest rates are currently at generational lows. In fact, in an effort to spur the flow of money around the economy, the Bank Prime Loan rate has been pushed down to at levels not seen in more than half a century.

At one point in 2008, the market saw investors buying short term Treasury securities with NEGATIVE interest rates. These poor souls were essentially using Treasury debt like safety deposit boxes, but for larger sums. They were willing to buy these securities KNOWING that they would lose money, and were happy to control their losses.

With interest rates so low, any rational investor should be asking themselves how much lower can they possibly go. Bond yields can only fall so far before demand simply dries up. The dangerous part of this equation is what happens after interest rates bottom.

When interest rates start back up – and they WILL start back up at some point – investors who buy bonds at such low interest rates will see their principle deteriorate extremely quickly. Bondholders who sell before maturity, but after interest rates have risen, will be forced to sell at a severe discount. Those who don’t sell, but hold to maturity, will be paid the full face value of their bonds, which is nice.

However, they will likely experience a tremendous loss of purchasing power, as a result of inflation that occurs between now and then. Moreover, these investors face substantial reinvestment risk, as they will be earning a below-market return for an extended period, as they wait for their bonds to mature.

Inflation, though a near-certain problem in the economy down the road, is unlikely to be nearly as bad as Glen Beck would have you believe. Many doomsday theorists point to the recent appalling expansion of the US monetary base as a signed death sentence by inflation. However, there is a way for governments around the world to avoid the hyperinflation that many consider inescapable.

Let’s revisit, for a moment, the risk bonds pose to investors’ principle, should interest rates rise. This aspect of bonds, though typically confined to a day or two of lectures in university finances classes, may deserve a place in political science curriculum in the near future. It is our contention that, through a form of defeasance, the government can successfully refinance a large portion of its debt after interest rates rise, thereby eliminating a significant portion of the national (Treasury) debt outstanding – by shifting the cost to bond investors in the form of mounting losses.

We all know that the government expanded the US monetary base (and in grotesque fashion) after the financial crisis began tearing through the economy. However, interest rates were already low when the government issued substantial amounts of new debt to fund new emergency facilities. Looking at a Monthly Statement of the Public Debt of the United States from the end of May, we can see that the vast majority of outstanding debt has a yield under 5% (United States Treasury).

Now, when the Federal Reserve under Jimmy Carter (and to a lesser extent Ronald Reagan) increased the US monetary base by 30%, the prime rate wound up peaking at over 20% when Paul Volker finally killed inflation (St. Louis Fed). This time around, the monetary base more than doubled. However, if prime rate ends up at just 15% (a conservative estimate, in our opinion), a good deal of Treasury debt issued at low interest rates could lose 66% of its face value.

The boys in Washington, after years of trial and error, seem to have finally perfected a system of paying for massive public debts, without ever sending the American people an invoice. Without raising taxes or tariffs, the government has been able to get the American people to pay for its absurd spending through losses and inflation.

In light of these revelations, and in view of recent controversy surrounding the secrecy of the Federal Reserve, it’s important for investors to remember that old quote from Mayer Amschel Rothschild, which we have used before and will certainly use again: “Give me control of a nation’s money and I care not who makes the laws.”

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