Sunday, January 2, 2011

The Surest Bet of 2010.... now the surest bet of 2011.

Namely, interest rates are going to rise.

Never mind that this has been the "smart money" thinking for the last 3 years, only to find interest rates remaining low. Never mind that there is very little evidence of inflation pressures in the most sectors of the economy.

No, the papers continue to be filled with confident predictions that out-of-control fiscal spending combined with easy monetary policy will almost certainly lead to higher interest rates.

I don't agree with the consensus - I think we continue to be in a disinflation, if not deflationary world - but what bothers me is that very few seem to worry about what happens if they're wrong.

I posted a note last week about the elderly couple who recently visited a local bank* in search of investment advice. One of the points made to the couple was that bond maturities in their account would be kept very short, since interest rates were sure to be rising very soon.

Well, this bank better be right, because their decision could prove to be very costly for their clients - not to mention the impact on their lifestyle.

Moreover, implicit in their advice is that they will be able to know when interest rates have reached the appropriate point at which it is "safe" to go back into the bond market.

Let me give an example. Let's just say the couple has $100,000 to invest in bonds. They aren't planning to trade their account actively - they are looking for fixed income to provide stability and some income for their daily living expenses.

Put another way, their "benchmark" is not any widely followed institutional benchmark (e.g. the Barclay Government/Corporate Index) but rather their investment portfolio allows them to live the way they would like.

If they follow the local bank's advice, their $100,000 invest will, for this year, produce essentially no income, since money market rates are around 0.2%. More precisely, if money market rates stay around current levels for all of 2011 (note that the Fed has given absolutely no indication that federal funds rates are due to rise any time soon), their bond portfolio will produce about $200.

Now, a couple of weeks ago, the Massachusetts Housing Authority issued AAA-rated bonds with maturities out to 2035. However, the bonds with a 12-year maturity had a 4% coupon.

Let's say our couple took their $100,000 and invested in 12-year bonds. This would produce $4,000 per year versus $200 in a money market fund.

Now, let's say our local bank is right, and interest rates go higher from here - but don't do so until 2013. Moreover, let's just say rates go from 4% to 6%.

By 2017, which was the better strategy?

Our unsophisticated investors who bought 4% bonds now would have earned $28,000 in 7 years. By comparison, our local bank's advice would have produced $24,600 (3 years of money market rates + 4 years of 6%). In other words, the "smart" bet would have actually been more harmful to the couple than if they had simply bought a bond for income, and not worried about price fluctuations.

My point of all of this is that I really believe we are entering a period when investors should be focused on two objectives: income plus capital appreciation. The latter cannot be really expected from bonds starting from today's levels - common stocks will have to fit the bill. No, bond should be viewed as income vehicles, with a little safety thrown in.

*no, this local bank was not my employer Boston Private Bank and Trust company