Game Plan

by Kevin D. Freeman

  Another attempt to inject money into the economy has been “Operation Twist,” which is designed to alter the yield curve. In this strategy, the Federal Reserve sold off an enormous amount of short-term debt and then used the cash to buy long-term debt. This maneuver injected money into the economy while at the same time lowering the interest rates for longer maturities—an obvious attempt at stimulus. The Fed announced, “The Committee expects economic growth to remain moderate over coming quarters and then to pick up very gradually. Consequently, the Committee anticipates that the unemployment rate will decline only slowly toward levels that it judges to be consistent with its dual mandate. Furthermore, strains in global financial markets continue to pose significant downside risks to the economic outlook.”13

  To summarize, the interest rate charged to any given borrower is determined by (a) the “risk-free” rate (which the Fed determines by buying and selling Treasury bills), (b) the borrower’s credit rating, (c) the economic forecast, and (d) Federal Reserve policy.

  Other Types of Bonds

  Investors can lend money to the federal government, state governments, foreign governments, non-profit organizations, corporations, and a variety of other borrowers. These borrowers offer different forms of bonds, each with its unique attributes. For example, municipal bonds are tax exempt, meaning that the interest they pay is exempt from federal and sometimes state taxation.

  Another popular type of bond is the so-called high-yield or “junk” bond. The companies issuing such bonds have low credit ratings. The bonds are speculative, but the returns can be quite high, as though you’re buying stock.

  What Happens When Interest Rates Rise?

  With all bonds, there is an inverse relationship between the price of the bond and its interest rate. If you hold a bond and interest rates rise, the price at which you can sell that bond goes down because it pays a lower interest rate than new bonds. If you bought a thousand-dollar bond with an annual interest rate of 7 percent and interest rates suddenly rise to 8 percent, nobody is now going to pay you face value for your bond that earns only 7 percent.14

  If there is an economic crisis and interest rates spike, short-term bonds (or bills) are not affected as severely as longer-term bonds. That makes sense because you can quickly roll over a short-term bond into another security paying the new higher rate. But if your money is in a thirty-year bond with a low rate, you have a long time to wait before you can roll over into an investment with a higher rate. So the price of long-term bonds is affected more severely by interest-rate changes than the price of short-term bonds is.

  Investment advisors like Rob Williams, the director of income planning for Charles Schwab, see a substantial risk of a crisis in the long term: “We see limited value and higher risks in long-term funds today compared to intermediate-term funds. The benefits of a slightly higher rate aren’t well-balanced with the increased interest-rate risk, in our view, for funds with average maturities much greater than 10 years. An exception might be if you’re focused on income and income alone and won’t need to sell, or if you believe that interest rates will fall. While we believe rates could stay lower longer than many investors expect, they will rise eventually.”15 John Waggoner of USA Today agrees: “Nevertheless, it’s hard to look at current yields and think that they will stay this low forever. (And, yes, many Japanese probably said the same thing in 1990.) . . . Long-term bonds get hit harder by rising rates than shorter-term ones. If interest rates rise 1 percentage point, to 3 percent, the value of a 10-year T-note would fall 8.6 percent. A 30-year bond’s price would fall nearly 20 percent. But a 3-year bond’s price would fall 2.8 percent.” Waggoner’s conclusion: “If you expect rates to rise, then you should consider funds that keep their duration short.”16 What is “duration”? As PIMCO explains, it is “a measurement of a bond’s interest rate risk that considers a bond’s maturity, yield, coupon and call features. These many factors are calculated into one number that measures how sensitive a bond’s price may be to interest rate changes. Generally, the higher a bond’s duration, the more its price will fall as interest rates rise.…”17

  Remember that the value of a bond is realized only when it is sold or cashed out. So if your bond is going through a bad time, there is usually time for it to recover. In other words, just because you have a bond at 7 percent and the current rate is 8 percent, you haven’t lost money until you sell, just as you don’t lose money on your home unless you sell it in a bad market.

  When Do Bonds Make Sense?

  In normal times, with low to moderate inflation, bonds can be a flexible store of value and provide opportunity for returns. Most investors should hold bonds as part of a diversified portfolio, depending on their age and risk tolerance. Bonds are designed to hold value. They are not growth oriented unless interest rates are high and expected to fall. Buying bonds in the early 1980s, for example, would have provided tremendous growth for investors.

  There are rules of thumb, such as subtracting your age from 100 (more recently 110 or 120) and investing that percentage in stocks with the rest in “safe” bonds. The thinking is that the younger you are, the more you can risk in stocks hoping for higher returns. Of course, the direction of interest rates, inflation levels, risk of default, Fed policy, and a host of other factors will determine whether a bond investment is successful.

  This book is not intended to be a primer on all things investing. It is necessary, however, to understand how bonds work so you can understand just how dangerous they can be under the right circumstances.

  In a deflationary environment, high-quality bonds, especially government bonds of financially sound countries, work very well. In fact, they are the investment of choice. When interest rates are dropping, bonds with higher interest rates are more valuable. Deflation will actually increase purchasing power over time, enhancing returns. If you lend $100,000 today at 2-percent interest, and if there is deflation of 2 percent, your $100,000 would have increased by the end of the year to $102,000 because of interest, and it would have $104,080 in purchasing power.

  In a deflationary environment, credit becomes tight and cash is king. So corporate bonds issued by companies with strong balance sheets will do fine. But high-risk (junk) bonds will struggle as the credit crunch puts many marginal companies out of business. Keith Springer, president of Capital Financial Advisory Services, says, “Short-term you’ve got a little bit left in stocks. Ultimately in a deflationary environment bonds are the place to be. The pros see deflation. What do you do in a low-interest environment? You buy bonds.” And as Americans worry about deflation, they turn increasingly to bonds.18 “You can tell from the Fed that they’re worried,” says Ryan Sweet, a senior economist at Moody’s. “The Fed has a playbook for dealing with inflation. They don’t have a playbook on deflation.”19

  In a major inflation, however, the opposite is true—long-term bonds are a terrible investment. If you buy a bond yielding 2 percent and inflation is 3 percent, you’re actually losing 1 percent on your money every year. Inflation destroys purchasing power, and long-term bonds provide a fixed rate of return, regardless of the inflation rate. This is why Warren Buffett believes that bonds may be riskier than stocks, at least if you believe there will be serious inflation: “The riskiness of an investment is not measured by beta [a Wall Street measurement of risk] … but rather by the probability . . . of that investment causing its owner a loss of purchasing power over his contemplated holding period. Assets can fluctuate greatly in price and not be risky as long as they are reasonably certain to deliver increased purchasing over the holding period. And … a non-fluctuating asset can be laden with risk.”20 Buffett’s view is supported by academic research. Javier Estrada, a professor of financial management at Barcelona’s IESE business school, evaluated bonds along two metrics: the possibility of destroyed purchasing power, and bonds’ underperformance of stocks. He found that stocks are unlikely to destroy purchasing power, and that bonds are more likely to do so than stocks. Stocks, he
found, aren’t as risky as bonds in the long term.21

  Some investment advisors believe that the bonds known as Treasury inflation-protected securities (TIPS) take much of the risk out of bond buying. These bonds allow principal to increase and decrease with inflation, measured by the consumer price index. They pay twice a year. The Treasury Department promotes TIPS as providing “protection against inflation.” But as Charles Wallace warns, “TIPS are a horrible investment when the economy is facing higher inflation.” Why? Because interest rates rise during inflation, so bond prices drop. As Jeremy Siegel of the University of Pennsylvania Wharton School of Business writes, “As economic growth recovers and real rates rise, the price of TIPS will fall, leaving TIPS investors with large losses in the face of accelerating inflation.”22

  The worst problem with owning bonds of any kind occurs when inflation suddenly spikes, as when a currency collapses. Bond interest rates jump from low to high quickly, and the old low-yield bonds can lose a great deal. As the Welton Investment Corporation points out, “[S] ince 1919 investors have experienced eight different corporate Aaa rate increase periods of +1.5% or greater, trough-to-peak. From the corresponding drawdown calculations, bond investors would have experienced peak losses between -7% to -24% over each of the eight periods identified. For example, periods like the 1950s were marked by a slow and steady rate rise, with Aaa losses reaching -15.3%. Other periods like the 1970s/early 1980s experienced sharp rate increases and produced deep acute bondholder losses in the -24% range.”

  Even a slow and steady rise in rates can be very painful for bond investors if the starting interest rate is very low:

  First, it’s important to recognize that bondholders are subject to additional interest rate risk when rates are low—in other words, at times like today. The most notable example of this occurred between 1954–1963.… [T]his period had one of the slowest and more moderate rate increases (just +1.8% peak-to-trough), and yet it produced one of the deepest (-15.3%) and longest (8+ years) drawdowns for bondholders. Why? After all, rates rose by a much greater +7.6% from 1977 to 1981. Faster rate increases should mean worse returns, right? In most cases, yes, but a key factor is that the starting yield in 1954 was only 2.85%, and for bondholders, the starting yield is critically important.

  When starting yield is low, any change is relatively substantial. But a quick loss of confidence (as might accompany a currency attack) can result in even more dramatic losses. The one-year impact of a sharp loss in confidence suggests that bonds could lose 34.8 percent in nominal value in a year, magnifying the loss of purchasing power inherent in the currency collapse itself.23

  So if the dollar were to fall quickly by 40 percent in international markets, the corresponding loss of confidence would cause the holdings to fall by another one-third or more. That means so-called “safe” assets could lose 60 percent or more in the course of a year, worse than the worst stock market decline of the past eighty years.

  Worries of a Bond Bubble

  Now, the United States has not suffered such a currency meltdown, and many believe it unlikely, if not impossible. But when you factor in the risks of financial terrorism and economic warfare, the unthinkable begins to seem possible. The fearful rush of investors into bonds because of their perceived safety only enhances the potential risks.

  Normally, investment bubbles are created by irrational greed, but overwhelming fear has its risks as well. Many observers see fear at work in the rush to bonds following the 2008 crash and believe that it has created a bubble in bonds, especially Treasuries. The yield is so low that it can’t drop further, meaning that the market is overheated. At some point, the Fed will raise rates, the thinking goes, killing the bond market. People generally think that Treasury yields will be higher in three to five years than they are today, although some experts say that the bubble will deflate gradually instead of bursting. Historically, huge bubble bursts have been relatively rare.24

  But there is the chance of a nightmare scenario. Michael T. Snyder of Seeking Alpha writes, “[I]f bond investors all over the globe start acting rationally, that is going to cause the largest bond bubble in the history of the planet to burst, and that will create utter devastation in the financial markets.”25 What happens if Snyder is right? If businesses can’t borrow cheaply, economic activity will slow down. If local governments can’t raise money cheaply with municipal bonds, they will have to resort to higher taxes, and some of them will go bankrupt.26 “We’ve intentionally blown the biggest government bond bubble in history,” says Andy Haldane, director of financial stability at the Bank of England. “Eventually interest rates have to normalize,” says Lloyd Blankfein, the head of Goldman Sachs. “It’s not normal to have 2 percent rates.”27

  How much damage would the bursting of a bond bubble inflict? According to the Bank for International Settlements, an organization of sixty of the world’s central banks, even a 3-percent rise in rates would cause American bond investors to lose more than $1 trillion, about 8 percent of gross domestic product. And that is not counting what the Federal Reserve would lose. The BIS believes that a return of interest rates to levels seen as historically normal could, “if not executed with great care,” undermine the stability of the financial system.28

  The famous investor and blogger Jim Rogers is certain that the bubble is going to break: “[A]t some point, markets won’t take central bank policies anymore, and interest rates go up regardless of how much bond buying they do. Market timing is tough. As for the fixed income market, I’m short junk bonds. In any market, the marginal stuff goes first. This could precede problems with sovereign debt.” He said he’d be buying more gold.29 Doug Casey, chairman of Casey Research, agrees: “Worst possible place to be is in bonds of any type. . . . This is going to be a bigger catastrophe than real estate when the bond bubble bursts.” He predicts inflation, interest rate increases, and default risk.30 Michael Hartnett, the chief investment strategist for Bank of America Corporation, warns, “Risks of a bond crash are high.”31 In January 2013 the chief operating officer of Goldman Sachs, Gary Cohn, said, “At some point, interest rates will go higher again, and all of the money that has piled into fixed income over the past three years, some of it will come out.”32

  The unstable situation of the bond market makes it a tempting target for financial terrorists. “You can see why the financial sector would be a particularly good target for someone wanting to wreak havoc through the cyber route,” says Haldane. “If I were to single out what for me would be [the] biggest risk to global financial stability right now it would be a disorderly reversion in the yields of government bonds globally.”33 And none of these dire forecasts includes the risks of a financial terror attack. Imagine what a force multiplier that would be.

  In a severe crisis, government bonds might be a worse investment than corporate bonds. Corporations have assets to sell, but governments rely on their taxing power. If the government is already running massive deficits, this power is limited. All government bonds are unsecured. So as the government incurs more debt, people will grow more wary of buying government bonds—they might not get paid back, except in inflated dollars that destroy the value of the repayment.

  The billionaire Wilbur Ross has said that long-term government debt is a ticking time bomb: “I think the greatest bubble that is about to burst is the 10-year and longer Treasury, because the idea that inflation is gone forever and for all time, and therefore these artificially low rates can last, is silly.”34

  Could the U.S. Government Simply Default?

  One of the most intense Washington debates in years took place in the autumn of 2013. The Republican party, led by House Speaker John Boehner, faced off against President Barack Obama and Senate Majority Leader Harry Reid over raising the federal debt ceiling. The White House argued that if the debt ceiling were not raised, the U.S. government would default on its debts. The House Republicans were ready to raise the debt ceiling but wanted some changes regarding how the new debt would be spen
t. All of this took place in the shadow of a “government shutdown” that resulted from the Senate’s refusal to pass the continuing resolution that originated in the House.35

  Partisan brawls over shutdowns and the debt ceiling have been a Washington staple for decades.36 While President Obama calls the actions by Congress unconscionable and unprecedented, he conveniently forgets that as a senator he actually voted against raising the debt ceiling, even as he was running for president. He now says he regrets that vote.37

  This is normal politics. It is unlikely that the government would default when in a position to continue to raise the debt ceiling and borrow more. But what happens if the government ever loses that ability? In August 2011 this same basic wrangling resulted in a downgrade in the rating of American government bonds.38 People panicked and rushed into government bonds. Yep, a downgrade of any other bond on the planet would cause investors to flee and rates to rise. But in the summer of 2011, such a downgrade actually increased the appeal of the very bonds that were questioned,39 reflecting the residual confidence that America will never default. But with each trillion dollars added to the national debt, that confidence is eroded.

  The federal government some day might default on its debt, but it won’t be because it refuses to borrow money. It would happen because the government couldn’t borrow enough to pay its bills come due.40 Various governments have defaulted in the past, although never one with the leadership position of the United States. Alex Pollock offered a sobering assessment of the risks in the Wall Street Journal:

  Twenty-first century economists, financial actors and regulators blithely talked of the “risk-free debt” of governments, and European bank regulators set a zero-capital requirement on the debt of their governments. The manifold proof of their error is that banks and other investors are now taking huge credit losses on their Greek government bonds.