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Wednesday, December 31, 2014

The Worst Case Scenario for Bonds

There are two bubbles in the world of securities currently.  Many of you have already heard about the "bubble" in Treasury (long-term) bonds, spanning more than two decades.  Despite U.S. 10 year, T-note yields being at levels (2%) not seen since the 1940's, people and countries keep buying them.  Expert economist, Robert J. Shiller, author of Irrational Exuberance, is coming out with a third edition adding an entire chapter to the current bond situation.  We know one thing for sure, The Fed has ceased their bond buying program (Q.E.), leaving only institutions, individuals, and nations to continue bidding up bond prices.


No one knows if The Fed will do as Yellen claims and progressively raise the Fed Funds rate, the interest rate that banks use to lend to each other.  A scenario where The Fed has to raise rates (to keep up with inflation) more aggressively could take shape.  It's not an impossible reality.  In this environment, holders of bonds with shorter maturities will benefit the most.  The consensus is for the status quo (demand for the Treasury holding and a progressive rate-hike by The Fed) to continue, however.  Gross Domestic Product (G.D.P) for the third quarter of 2014 was upwardly revised to 5%.  That's quite an acceleration in economic growth.  Is this result an outlier?  Let's hope so for the sake of all status quo believers.

Money magazine's 2015 January-February edition had an excellent article on the bond market: How 2% explains the world.  The article shared why we can expect a slow growth environment, with bond yields rising ever so slowly, for years to come.  Why?  The economies of Europe and Japan, badly in need of economic spurring, will keep their own long-term bond yields low with Quantitive Easing of their own.

"The 10-year German government bond, for example, yields only 0.6%.  That essentially exports low rates to the U.S., as foreign investors buy up Treasuries. " --author, Pat Regnier.

"Our 2% or 3% looks cheap next to Japan and Europe." --Elaine Stokes, co-manager of Loomis Sayles Bond.  Also cited in this article.

If you own bonds individually, and look to hold them to maturity, none of this (fluctuations in rates) really matters.  You'll get your capital back in the end.  However, if you own a bond mutual or exchange-traded fund..."sharp movements in rates can translate into significant capital gains or losses," said Regnier.

If you don't subscribe to Money Magazine, and are looking to up your financial literacy, you should consider signing-up.  This magazine is great for beginners.  There's an Amazon link on my left sidebar that you can click to purchase a subscription.

Worst Case Scenario for Treasuries

The worst case scenario for long-term bonds, stocks, the world in general is a sudden, panicked, shift in demand for our 10-year Treasury.  What would cause people to frantically sell their treasuries and yank out the 90+ trillion dollars currently held in the bond market?

U.S. Debt!  Washington's debt recently crashed past the 100% threshold of GDP.  Our debt is at 17+ trillion dollars and rising, not factoring in state and household debt.  If these two other factors are added, our total debt is upward of 62 trillion dollars, some 380% of GDP!  Even more worrisome, unfunded liabilities like Medicare are not included in these stats.

I wouldn't believe the chart below.  We are way past 100% fed debt/GDP!

Dailywealth.com/entitlements-spending-unemployment


Can we count on our politicians to address our debt problem?  I'll leave this question for you to answer.

This whole situation can best be described as a powder keg.  But what will or can light the match?

Well so far, the U.S. has been able to fund its ballooning debt by selling treasuries.  The U.S. government then uses the proceeds to pay its bills.

What if the U.S. lost all of its buyers?  Can that really happen?  We have a broke government with a spending problem, and you can imagine the often used metaphor of not being discovered in the nude until the tide recedes.  Is the 10-year Treasury (everyone's benchmark as the risk-free rate of return) truly "risk-free," as they are advertised?

gouldasset.com/blog/  Increasing demand for the 10-Year T-Note has caused yields to plummet.  Decreasing demand will cause the reverse, similar to the pattern seen from 1962-1982.

From 1962-1982, 10-year US bond yields rose some 300%!  When the current bond bubble finally busts, will we see it happening and have time to adjust or will it happen much like the 2008 credit crisis that left all of us with our pants down?

Imagine trying to finance purchases (your home, a car, etc.) at pre-1986 rates?  We've had it good for a long time!  Don't worry, the whole world is in debt practically.  Debt runs the world!  But...at the core of all of this debt is the U.S. Treasury, the world's benchmark.

In 2011, Bill Gross of PIMCO, known as the world's smartest bond investor, turned away from treasuries altogether, leaving the Total Return Fund he managed with $0 in just nine months time.  At one point, the fund held $147+ billion in treasuries.  The move proved untimely and devastating.  U.S. treasuries (prices) have gained through 2014.  He was convinced the U.S. is already in default and that it cannot pay back its debt.  Indeed, many share his sentiment, including myself.

Are T-note investors paying too much, bearing more risk then they are aware of, for such a paltry return?  The smart money has been slowly leaving the long-term duration bond in favor of shorter term duration, and equities.  This is why 2014 was a successful year for stock market investors.  Only there are many individuals still holding on to their 10-year T-Notes, just keeping up with inflation at 1.8%.  Retirees, pensions, millennials, generation x'ers, etc., with long-term duration bond allocations/exposure (in mutual or exchange-traded funds) will lose money when interest rates begin to rise.

Only when the tide goes out do you discover who's been swimming naked.--Warren Buffett

The worst case scenario for the bond market is a loss of confidence in the U.S.  If China, Japan, England, any sovereign nation for that matter, flee treasuries, for reasons that could include, fear of default and the U.S. recovery being more speedy than expected, many will be left standing naked when the tide recedes.  The U.S. government would have to make haste in raising yields to be able to continue selling treasuries to finance our debt.  Don't count on any manipulation.  Whereas The Fed controls the Fed Funds rate, and yields on short-terms, the bond market itself is responsible for rates on the T-note.

Did you know?

Eight times a year, the Treasury Department holds an auction for U.S. treasuries.  Who participates?  Nations like China, Japan, etc., big banks, and Wall Street institutions.  Again, soaring demand has bid up prices, and the U.S. government has gotten away with being able to pay low interest rates.  As of today, there is no problem, finding buyers, that is.  But what if...?

China quietly sold off $136 billion worth in treasuries it owned in a nine month period.  fpc.state.gov/documents/organization/175863.pdf  Great Britain reduced its stake from $347 to $244 billion.

A bad announcement would be the fuse that lights the powder keg in the Treasury bond bubble.  A just-released announcement, after all, is what the masses react to in any market.

What if the major players who show up to one of the eight upcoming auctions decide not to buy the Treasury, seeing asking prices as being too high?  What then would ensue?  A "just-released" announcement, of course!  The failure to attract any buyer would publish to the world in minutes, causing Treasury interest rates to suddenly spike and prices to fall...a chain reaction sell-off.  The world's "safest" investment would become the "riskiest" in this bust scenario.

What can you do?

Get out of long term and get into short term maturity bonds, for starters.  I have started a position in Pro-Shares Ultra Short 20+ Year Treasury (TBT), and will continue to slowly build on my position.  By the way, this ETF has returned -37% YTD!  This is great; only a floor remains (it may be there already) before the upside begins!

Sophisticated investors may want to consider Float Funds.  These funds represent a very small, niche, market and offer investors dividends in any type of rising interest rate scenario (slow or fast).  With any investment, there are risks, and of course, these Float Fund investments are not any different.  So consult with your financial advisor.


At the start of this post I mentioned there being two current bubbles in the world of securities.  The other "bubble" I feel exists is with the Total Stock Market Index fund.  Look for my next post to read why this asset class for me is neither safe nor of any special quality.

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