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.
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.