"The Times They Are a-Changin'"-By Ron Roge | May 14, 2013

The Times They are a-Changin’ | By: Ron Rogé


“Come gather ’round people
Wherever you roam
And admit that the waters
Around you have grown
And accept it that soon
You’ll be drenched to the bone
If your time to you
Is worth savin’
Then you better start swimmin’
Or you’ll sink like a stone
For the times they are a-changin’.”

These lyrics, by Bob Dylan, came to my mind after seeing some recent comments and news items about the bond market.

First, Bill Gross, Co-Chief Investment Officer of PIMCO, the world’s largest manager of bonds, tweeted on May 10, 2013, that “The secular 30-yr bull market in bonds likely ended 4/29/13. PIMCO can help you navigate a likely lower 2-3% future.”

Today he Tweeted again on May 13, 2013, that “The 30-yr bond mkt over but bear mkt begins only with consistent 2-3% real & 4-5% nominal GDP growth. Not there yet. Maybe never.”

I am not sure if Bill was clarifying his previous Tweet or perhaps, just changed his mind about calling a bottom in the bond market. It doesn’t really matter. The point I want to make, here, is that even the person we call “The Bond King”, who manages several trillion dollars in bonds, is struggling to figure out the upside down world we live and invest in today.

The Federal Reserve’s Policy of Financial Repression

Perhaps we should be more concerned about the Federal Reserve’s announcement last week that it has mapped out a strategy to exit from its stimulus plan. This is where the Fed has been purchasing an unprecedented amount ($85 billion a month) of bonds. This program is what Bill Gross and his team at PIMCO, have dubbed “Financial Repression” This Fed policy punishes savers in fixed instruments such as Certificates of Deposit (CD’s), bank savings accounts, money market funds and bonds with negative real interest rates. This policy is destroying purchasing power for investors in these instruments. It is also forcing investors to seek out higher yields and take on more risk. So much so, that last week the spread of Junk Bonds to Treasuries fell to an all time low of 4%. Historically, this should be about 7%. It demonstrates the demand for higher yield. It is also forcing investors back into the stock market where there is more risk but also more reward. In today’s upside down world, the risk/reward ratio of stocks is much better than bonds.

So, you ask, “What is the Fed’s plan?”

FLEXIBILITY.

They will monitor the economy and may cut back, may do nothing or may increase purchases of bonds. There is nothing new here,

so why announce it? Perhaps they don’t want us to get too comfortable in thinking the Fed is on hold forever with its current policies. After all, the unemployment rate is decreasing, the housing market is returning, prices of existing homes are increasing, corporate earnings are good and driving stock prices higher. So, there are signs that the economy is improving and perhaps the Fed wants to be proactive with raising interest rates. If they get it wrong, it could cause a recession which they hope to avoid that at this point.

What can be done to Mitigate this Bond Market Risk?

In a more normal economy, when there is a risk of an interest rate increase the solution is usually easy. You begin by reducing your exposure to bonds and moving to money market funds, which, by design, will pay an increasing yield as rates rise. You can also lower the duration of your bond exposure in your portfolio.

With today’s money market fund yields paying less than 0.01% annually, we actually get a real negative yield. Therefore, it is painful to have any material amount of money invested in money market funds for any period of time. So this tactic today is not palatable for most investors, because we don’t know how long the Fed will remain on hold. Like Bill Gross says – “Maybe never.”

Lowering the duration of the bond portion of one’s portfolio is still a tactic we can use today, but we give up yield in doing so. With yields so low to begin with we need to be careful that we try and maintain real purchasing power for our clients.

Reducing our allocation to bonds by 5% to 10% and reinvesting those proceeds in dividend growing equities is an alternative tactic. However, as an investment advisor, we need to make sure we keep the risk/reward ratio of the overall portfolio in range for our client’s tolerance for risk.

As with all investing we need to keep our eyes on the Fed, be patient and not throw the baby out with the bathwater in a panic. We are preparing for an eventual increase in interest rates by utilizing the tactics listed above. I am confident that our overriding strategy of investing in globally balanced, risk adjusted portfolios along with these tactics will help us navigate through this problem as it has in the past. Stay tuned, as “the times they are a-changin’.”

 

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