Titled "Some Do's and Don't About Leverage", the author Paul Sullivan offered a number of situations where it might make sense for people to borrow money, and when it might not.
However, this was the part of the article that caught my client's eye:
At the same time, many more people are taking on more risk than they may realize.
The other side of borrowing money is lending it, and that is what the
millions of people who have bought United States Treasuries have done.
Being a lender to the federal government carries risks if inflation
increases or the economy improves enough that people start selling their
Treasury bonds to get higher yields elsewhere.
“What we’re telling our clients is it’s an incredibly dangerous time to
be a lender, particularly to the U.S. government because rates are at
historic lows,” said Joseph J. Duran, chief executive of United Capital
Financial Partners. “If the economy picks up steam and we get any
inflation, it will have a huge impact on returns.”
Here's in part how I responded to my client:
There is no denying that interest rates are at 60
year lows, and it seems reasonable to expect that rates will be moving higher
at some point. The question is, however,
when this will happen.
The Fed is publicly committed to keeping interest rates
low until 2014, if not longer. If short
rates stay at essentially 0%, then, how much can interest rates climb?
Your fixed income portfolio consists of higher quality
bonds that have laddered maturities. If
interest rates were to move higher, the market value of your bonds would
decline, but eventually all of your bonds will mature at par (100).
This is not true, by the way, for investors
in bond mutual funds - these folks have more principal risk than they are
probably aware of.
The duration of all of the bonds in your portfolio is 4.6
years. "Duration" is a mathematical measure of the price sensitivity
to changes in interest rates. If
interest rates were to move up 100 basis points, for example, the overall
market value of your fixed income portfolio would decline around -4.6%.
The article quotes an financial advisor talking about the
price sensitivity of a 30 year Treasury to changes in interest rates. The duration of a 30 year bond is 18 years,
so he is correct that the market value of a 30 year bond would decline by -18%
if rates were to rise by 100 basis points. However, this is a little
misleading, since I doubt that any investor has a bond portfolio consisting
only of 30 year bonds.
All of this probably sounds like I am not concerned about
your bond portfolio, which is generally true.
However, I am not thrilled with the low rate of return you are receiving
for 45% of your investment portfolios here, especially with the concomitant market
value risk. Stocks may be risky, but at
least they offer some potential upside as well as future inflation
protection. In addition, the dividend
yields on many of your holdings is actually higher than bonds issued by the
same corporations.
In other words, while there is no doubt that the market
could "correct" at any time, stocks offer a considerably better
opportunity than bonds at the present time, in my opinion.
Finally, I wanted to bring to your attention a piece written by economist Carmen Reinhart on Bloomberg. Ms. Reinhart is a senior fellow at the Peterson
Institute for International Economics in Washington, is the
author, with Kenneth S. Rogoff, of “This Time is Different:
Eight Centuries of Financial Folly.”
In Professor Reinhart's opinion, today's low level of interest rates is just another way that governments has historically taken funds from savers and investors to pay their own debts. She calls this "financial repression":
...One of the main goals of financial repression is to keep nominal
interest rates lower than would otherwise prevail. This effect,
other things being equal, reduces governments’ interest expenses
for a given stock of debt and contributes to deficit reduction.
However, when financial repression produces negative real
interest rates and reduces or liquidates existing debts, it is a
transfer from creditors (savers) to borrowers and, in some
cases, governments.
This amounts to a tax that has interesting political-
economy properties. Unlike income, consumption or sales taxes,
the “repression” tax rate is determined by factors such as
financial regulations and inflation performance, which are
opaque -- if not invisible -- to the highly politicized realm of
fiscal policy. Given that deficit reduction usually involves
highly unpopular spending cuts and/or tax increases, the
“stealthier” financial-repression tax may be a more politically
palatable alternative.
http://www.bloomberg.com/news/2012-03-11/financial-repression-has-come-back-to-stay-carmen-m-reinhart.html
The debt of the US government, for example, has expanded by $5 trillion in the past few years (!) yet its annual interest expense has reminded essentially the same as it was in 2009.
The policy of the Fed, in other words, has not only helped home buyers obtain cheap mortgage financing; it has also allow our government to continue to borrow freely with no immediate hit to the budget.
This will eventually change, of course, but for now the course of interest rates seems steady.
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