In real estate there are three magic words, “location, location, location.” Investors in financial markets, when looking for safety, covet their own magic words, “bonds, bonds, bonds.” This seems to be a panacea for conservative investors who are not willing to take on a lot of risk in their portfolios. However, there is a word of caution for all “low” risk investors as we move out of this low interest rate environment.
Massive budget deficits and debts, plus a growing concern about credit quality of government debts, should signal a bearish outlook for the bond market in the next few years. In fact, Moody’s Investors Service warned that both U.S. and the U.K. are “substantially” closer to losing their AAA debt ratings. Moody’s estimates that the U.S. will have to spend more than 10% in revenue just to pay off the interest on the growing debt by 2013. A key reason why? Debt service costs –ongoing interest and principal payments-are surging.
We’re also seeing better economic data and a stronger economy. There is one problem with this recovery. It is an economic recovery whose growth has been bought and paid for by Washington. In other words, we are using borrowed money to prop up this recovery which in the short term adds to a growing debt. Here is some of the data that is pointing to a stronger recovery:
Housing starts and building permits are holding steady in the 550,000 to 650,000 range, rather than deteriorating further. This fits with the major housing market bottom.
Industrial production rose 0.1 percent in February, while capacity utilization rose to 72.7 percent. That was the eighth month in a row of improvement in the utilization rate. It’s now at a 14-month high.
Retail sales rose 0.3 percent, while “core” sales excluding autos climbed 0.8 percent. Both figures topped estimates.
Even consumer credit rose by $5 billion in January, the first monthly rise in a year.
So, why is a growing economy bad for the bond markets? It puts more pressure on bond prices, helping to push interest rates higher. The Federal Reserve can only control interest rates on short-term borrowing. The Fed continued its pledge to keep short-term interest rates at “exceptionally low levels” for an “extended period.” This artificial cap will put more pressure on bond prices and force interest rates higher.
To protect your portfolio from too much risk you should stick with short-term bonds. Do not hold bonds with a maturity of more than five years. Buy individual bonds, if possible. If you are invested in bond funds look for ones with short-term durations and maturities.
This time around, when thinking about bonds, use these three magic words, “short-term, short-term, short-term.”