Bond, interest rates and why no one gets it
Posted by Ray on December 28, 2009 under Main | 
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Regular readers know that I am or have become a bigger proponent of income investing lately and if you don’t know what I am talking about you should be reading my material more. However, there seems to be preconceived disconnect with my philosophy and what you believe to be true about interest rates moving forward. Some people see my bullishness on bonds in the face of rising interest rates as purely insane, especially given what treasuries are doing, but I can assure you it is not.
Keep in mind I am talking about investment grade corporate bonds and high yield bonds, my favorites are ‘BB’ and ‘BBB’ rate paper in an ETF format, I do not like mutual funds because of the once a day pricing. As an aside I do like selective sovereign debt as well, but don’t go out and buy Eastern European government debt or anything, be selective as the risk return is there, but supply is going to be an issue moving forward so it will pay to be extremely selective in 2010. Anyhow, back to corporate debt and why I like it.
Treasuries are entering a bear market for the first time in my memory and I expect there to be a bear market until the next crisis hits, so for only a few months. The reason there is a bear market is simple, supply, end of story. You cannot issue an endless amount of paper and expect the market to eagerly accept it without paying more for it because people, foreign central banks in this case, know they will never fully be repaid for the US debt they buy now, it is mathematically impossible for the US to repay its debt so don’t shoot the messenger hate the calculator. Because of that mathematical probability interest rates on treasuries are going higher and, according to those wonderfully bullish, and misguided, government data figures investors are pricing in interest rate hikes which kill treasuries and other high grade corporate debt, high grade being the operative word, so remember that please.
High grade corporate debt is technically, and in my opinion, anything rated higher than ‘A’ and issues interest rates slightly above treasury yields. We are talking about your really safe corporate paper issued by IBM and similar firms. Essentially, those are a riskless investment which is why your yield is so close to treasuries and why those bonds will get crushed when/if interest rates go higher. For those who do not understand how bonds work think of bonds and interest rates like a teeter-totter with interest rates on one side and bond prices on the other side, when one goes up the other side goes down. Therefore rising interest rates are bad for bonds because new bond issues will have higher yields so your existing bond will have less appeal in the marketplace and if rates go down new issue bonds will have lower rates which means your existing bond will be more attractive because it has a higher interest rate. Make sense, good.
All of that is important because we are at zero interest, technically we are in the negative interest rate area because of quantitative easing and deflation which is bond friendly. However, this red hot economy we are in, sarcasm is my trademark, many people are expecting an interest rate hike to happen at some time this year and they are right. The Fed will raise interest rates in 2010 from 0-.25% to .25-.50%, wow. There is an outside chance that rates may go to 1% by the end of the year, but that is pure speculation right now because the economic data or ‘recovery’ is spotty at best. Even if rates go up it is relatively meaningless to lower grade corporate bonds because it does not hurt the spread as badly as it does for higher grade corporate bonds.
What I mean is newer higher grade corporate debt and treasury debt will have higher yields than current issues so existing paper will get slammed. However, existing lower quality corporate paper will do OK as we would need rates to go up substantially in order to really hurt the spread. I am not saying that there is no risk in lower quality corporate debt, defaults will be a huge issue moving forward, but I am also betting that the Fed’s liquidity programs end up not going away either. In fact, I would speculate that the Fed’s balance sheet will continue to expand over the next 12 months, perhaps double again if the FASB gets its way and the SIV’s have to be added to banks balance sheets right away, but again that is speculation right now.
If the Fed does actually raise interest rates this would be a bullish signal to the markets because it means we have real growth in the economy as well. This means lower grade paper would perform better, even if that growth is only at lower levels. However, higher interest rates will not be good for stocks, in my opinion, which is why I shifted focus to lower quality corporate bonds and to companies like Alteria. I would not expect, even if the economy is cruising, to see rates go much higher than 1-1.5% though because the Fed is stuck and it cannot move rates higher or to a meaningful level ever again. Regardless, corporate bonds of ‘BBB’ or ‘BB’ and selective ‘junk’ should do OK moving forward in the face of higher interest rates because of what I said previously. We will not see huge returns like that of 2009, but I think they will do better than stocks moving forward, plus you are first in line when the company folds, something to think about.
Why the Fed is stuck
What do I mean by that, a meaningful level? You see, the US is in a debt trap that we cannot escape from, it is simple mathematics. The Fed will not be raising rates to protect the dollar, they want a weak dollar that is for another post, they do not really care about inflation as they really want massive inflation but we cannot create it. The Fed will raise interest rates to keep politicians off of its back and that is about it, but raising rates higher than 1.5% presents problems that the US cannot handle.
Congress just had to raise the debt ceiling by a few hundred billion to fund the government for the next 6-8 weeks, unbelievable, and a more ‘permanent’ fix of raising the debt ceiling to about $14T will be coming soon.
I know this is no big deal to liberal democrats because, after all, under Bush we had to raise the debt ceiling 7 times and to them 8 or 9 wrongs make a right, but this is a major, major problem. Considering that raising the debt ceiling to $14T moves the total US debt to just about 100% of GDP marks a new low for the US and is the greatest amount of debt any country has ever attempted. What I am saying is that our current debt servicing costs with the Fed holding rates at 0% and using QE is about $500B+ a year and our average maturity of our debt is less than 10 years, again this is a first in all of the world’s history.
If the Fed moves rates up past 1.5% then that debt servicing cost will go up, dramatically, and there will be major consequences that the American people are not ready to face. Forget the debt ceiling, we will repeal that silly little rule, especially since we have to raise it almost every year anyhow. Within 7 years out debt servicing costs will begin to take its toll on the national budget squeezing out typically paid for items, like earmarks. Defense spending will have to decline immensely which is why the US remains a superpower even though we have a relatively small manned military compared to say a China, India or North Korea. The dollar will decline much further, it will anyhow as the latest rally, which I anticipated, is a head fake and was driven by Dubai, Greece, Fear, short covering and the selling will comeback harder and faster than you could ever imagine.
All of the senseless spending is coming home to roost, now. China is telling us where to stick it as there is not enough dollars to buy our debt, which is kind of funny in a sick way, and they said no to strengthening their Yuan which makes sense for them and smells of protectionism to me. When we demand a foreign country make their products more expensive in the US just so we can shrink out trade deficit thereby boosting our GDP and sell more products to them that is protectionism, straight up. I do not like to be so grime, but many of the things I foresaw and have been keeping to myself are coming out in the open. Things are not good, but hey as long as the market keeps going up, who cares right? Well, you will when it comes crashing down around you. Fixed income never looked so attractive right now.
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