Bonds Fall 2009

Bond Market Analysis – Fall 2009

With interest rates driven down by the Fed, bonds continue to have high interest rate risk. Bond values go down when interest rates go up. The Fed has made it clear when the economy can handle it, interest rates will have to rise without the artificial monetary policy now keeping rates so low.

As the Wall Street Journal 10/13/09 warns: For every one-point rise in the federal funds and other interest rates, the price of a 10-year Treasury decreases by 8.5%; a rise of two percentage points would chop a 10-year Treasury bond's value by 17%. Muni bonds with the same maturity would mathematically fall more.

While the Fed wants to put off rate increases until the economy is stronger, "Federal Reserve official, Kevin Warsh, rattled bond investors late last month by saying increases may come 'with greater swiftness.' The Fed controls only short-term rates, but pushing them up often affects longer-term rates.

Higher interest rates may be needed to defend the dollar, keep inflation low and to fund the U.S. deficit. The result would be a decline in bond values unless held to maturity. Holding to maturity results in lost opportunity cost since interest earnings would be below market rates if interest rates increase.

U.S. Debt Funding - As the U.S. debt mounts higher yields may be needed on Treasury borrowings. Most other bond yields are based on what is called a "spread" over risk-free Treasuries. The spread varies based on the relative risk of different bonds.

This year the U.S. Treasury has managed to borrow nearly $2 trillion at surprisingly low interest rates. Recent Treasury auctions have enjoyed a healthy 2.5 to 3.0 coverage ratio. This means 250%-300% demand for the available bonds. Foreign buying has declined somewhat but has been replaced by stronger domestic buying with the current increase in the savings rate. Also the borrowing requirements have been less than expected due to the large profits on TARP funds to banks and with the 2009 fiscal year budget deficit or less than earlier projected.

Dollar Support - At some point if the dollar continues to fall in value, higher interest rates may be needed since this is the primary factor in currency valuations.

After weakening gradually since 2002, the dollar rose during the financial crisis of 2008 when money was flowing into "safe" investments. Safety is no longer the issue that it was in 2008. As of 10/17/09 the dollar has fallen about 15% since March 2009. Many global economies are looking at recovery and money is flowing into higher yielding currencies.

On 10/6/09 Australia was the first major Central Bank to increase interest rates to 3.25% vs. 0-0.25% in the U.S. This resulted in a sharp dollar decline. Nations such as Australia, Israel, Norway and Brazil that remained relatively isolated from the economic turmoil of the past 12 months for various reasons now appear to be leaning toward tightening their interest-rate policies to head off inflation.

But central banks in the big economies at the center of the crisis, including the U.S., Europe and the U. K., are still nursing wounded economies and look likely to keep interest rates extremely low for many months to come. U.S. Federal Reserve officials have spoken extensively about their strategy for exiting from their low interest-rate policy in recent months, but want to wait until the economy is stronger.

Much of the world other than Japan has higher interest rates than in the U.S., which is attracting more bond investing in other currencies as well as foreign equity investments.

A falling dollar usually helps U.S. economic growth since it makes our exports cheaper and encourages foreign tourists to come to the U.S.

On the negative side it makes imports more expensive which can result in higher inflation and discourages foreign buyers of our debt. Higher inflation also drives interest rates higher as the Fed tries to fight inflation.

On 10/16/09 Treasury Secretary Geithner said that maintaining the dollars status as the world's reserve currency entails the responsibility to keep the dollar's value from eroding and to keep inflation low. This would require higher interest rates.

Buy Quality Stocks, Sell Treasuries - Morningstar 10/19/09 - "A natural consequence of the high level of risk aversion has been a large move in U.S. Treasury securities. When you look at the 10-year note with a 3.4 percent yield, it's a reasonable case that equity markets will deliver much higher returns in the next decade--even adjusted for risk. So what may appear to be among the least risky assets may be among the riskiest, at least if you take opportunity cost into consideration."

Junk Bonds Leap may be over - These bonds were priced for Depression levels of defaults. When the depression fear ended they had strong gains as widespread defaults were avoided. Spreads over quality bonds are now near historic averages so the small extra yield may not be worth the risk. Now, the interest rate risk may be high if we eventually have to have higher overall interest rates to fund the deficit or defend against the weakening dollar.

Bond Ebullience Is Raising Eyebrows - Wall Street Journal 10/15/09 - Even some bond fund managers are surprised by investors continuing appetite for bonds and are warning about them. "Investors may be in for a shock when rates eventually rise." Fund managers report record inflow into bond funds and very little yet flowing into equity funds.

Investors are being lured by this year’s total returns which include the increase in value as interest rates were cut by the Fed on short term debt to almost 0%. This increased bond values across the board. But you can't go much lower. Yet investors are being drawn in by these total returns even though they can't be continued and now the risk is for higher rate with the correspondingly decline in bond values.

The rumors of the dollar's death are exaggerated - Financial Times 10/13/09 - Article points out that the dollar decline is helpful in many ways for the U.S. economy. The rumors about replacing the dollar are not realistic. What will replace the dollar as the major world currency? The Euro is the dollars only serious competitor. Not China with its exchange controls and a non liquid market. Today 65% of the world’s reserves are in dollars and 25% in Euros. The Eurozone countries also have high fiscal deficits and debts. "The dollar will exist 30 years from now; the euro's fate is less certain."

Many Retirees May Need Higher Returns than what Bonds Yield – Since at a Fed rate of near 0% there is not much opportunity for bond value gains, bond investors have to look at yields only. They cannot count on increases in market values, and have a high risk of values declining due to higher interest rates if they need to sell before maturity.

This is especially a concern for medical expenses in retirement not to mention the potential of the need for long-term care. These concerns increase as medical science extends life expectancy even to 100 for some folks. Bigger retirement nest eggs will also be needed for a spouse compared to past generations where many folks retried at 65 and died in their early 70s. Today we often live much longer. Many retirees need higher returns than bonds offer to achieve long-term financial security.

New tab for retirement health care: $240,000

The cost of health care in retirement has risen 50% since 2002, according to research by Fidelity Investments.

A 65-year-old couple retiring this year will need about $240,000 to cover medical expenses in retirement apart from Medicare insurance. The analysis assumes that the individuals do not have health care coverage provided by their employers. The estimate includes Medicare deductibles, copayments and certain services that might not be covered by Medicare.

The estimate does not include other expenses such as over-the-counter medications, most dental services and long-term care.

It is based on the assumption that the men will live to age 83 and the women to 86. Many today are living to even older ages. Living to age 100 is even becoming more common with medical advances.

With employee-sponsored retiree health care coverage on the decline nationwide, it is imperative that today’s workers begin to set aside money themselves for medical expenses in retirement as part of their overall retirement strategy.

Another study by The Center for Retirement Research at Boston College says: To cover projected out-of-pocket health care costs, a boomer couple retiring in 2010 will need to put about $206,000 in an annuity.

Depending on your objectives we can recommend alternatives to U.S. bonds which have such high interest rate risk once rates return to more historical averages.

The views and opinions expressed by Dave Hutchison, CFP are as of the date of the report, and are subject to change at any time based upon market or other conditions. The material contained herein is for informational purposes only and should not be construed as investment advice, since recommendations will vary based on a client’s goals and objectives. Information is believed to be from reliable sources; however, no representation is made as to its accuracy. All economic and performance information is historical and not indicative of future results. Please consult one of our financial advisors for more information. Hutchison Investment Advisors, Inc. is an Arizona registered investment advisor. Part II of Form ADV (Disclosure Statement) has been given advisory clients and is available upon request and is at www.davecfp.com

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