Time to Get Serious About The Bond Bubble Bursting

Time to Get Serious About The Bond Bubble Bursting

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As 10 year bond yields have gone from 1.80% to 2.15% over the last month, Janet Yellen, Bill Gross, Jeffrey Gundlach, Scott Mather and many others have made statements indicating that the bond bubble may finally be ready to burst. It is time to get serious about the potential consequences of the bond bubble bursting.

In 2013, the 10-year bond went to a 3.05% yield briefly.   Many traders who were heavily long fixed income got really hurt when this happened, but the general public was spared from the consequences of a end of cheap money as cash from global markets began pouring into the US to drive rates back down.

At this point, many experts are indicating that the current 10 year yields are well below where they should be at this point in the economic cycle and they should begin to move off of the unnatural post-recession lows that we have seen for the last 6 years in anticipation of a change in Fed policy.  Janet Yellen, herself, has indicated that the cycle of unnaturally low interest rates needs to come to an end and that when it does long term rates may spike higher.  High profile observers – including Bill Gross, Jeffrey Gundlach and Scott Mather - have all been quoted in mainstream financial media over the last several days as suggesting that as the Fed begins to raise rates, long bonds will go up more quickly.   Even if the rise in the Fed Funds rate is extremely slow and deliberate, 10 year rates will wind up back to 4% or 5% over the next year or two.

This is a good time to confront reality.  If 10 year rates were to go back to 4 or 5% (or 6 or 7%), the discounted present value of that cash produced by instruments that you may hold will become less valuable (i.e., will become discounted at a higher rate).   The value of long-term municipal bonds will fall.  Corporate bond spreads will widen, not narrow, and the value of corporate (high grade and high yield) bonds that you hold will fall sharply.  The value of your emerging market bond and EM bond funds will fall dramatically, as will the value of any preferred stock that you may hold (including Public Storage’s preferred stock that I have previously recommended). 

I do not pretend to be a real estate or a stock market expert, but it would seem that your real estate and equities will impacted as well.  Real estate values in frothy markets like New York, San Francisco and Miami may fall from their bubble levels as mortgage rates rise.  Stocks – including Blue Chip stocks such as Disney, Procter & Gamble, McDonalds and Coke – that trade at extremely high, above-market multiples of earnings against anemic growth will see a sharp correction.   (The broader market however may move higher and fast growing, dynamic growth stocks with large cash stockpiles, very low PE ratios, and PEG ratios below 1 such as Apple and Gilead should be virtually unaffected and continue to move dramatically higher).

This is probably not the time to sell your home or exit the stock market.  But, it is a good time to think about some key things you can do to protect yourself from a rise in interest rates.

1.  Think about raising cash, selling your bonds (except for those nearing maturity), bond funds, bond like instruments, and stocks with unsustainable valuations.  Earning 1% a year over the next two years is a better outcome than losing 20% or more of your principal over that period.    If you still aren’t earning 1% on savings, see this list of the highest yielding savings accounts.

2.  Put money in CDs.  You can earn 2.25% on a 5 year CD from Synchrony or Barclay’s Bank that allows only a six month interest penalty for early withdrawal.  As this article discusses, that is a pretty reasonable risk-reward scenario.  Alternatively, put your money in a CD that offers a better rate than cash and provides the opportunity to raise your rate should rates rise.  CIT Bank’s family of RampUp CDs are not only among the highest yielding CDs, but offer this flexibility.

3.   Invest in structured notes that are geared to pay out more money as interest rates rise.  I have written extensively about these notes on BestCashCow.  My favorite notes are those that pay a multiple of the spread between the 2 year and the 30 year Treasury (or Constant Maturity Swap) rates.  While this notes usually require assuming the credit of a bank, such as Chase or Morgan Stanley, they are currently paying around 6% and would move to paying their maximum distribution amounts of 9% to 10% should the interest rate spread widen.   These notes may not always be offered in primary markets and can be difficult to find in secondary markets.  Read my earlier articles on these notes here or here.

Happy investing.      


Acorns Investing App Makes It Easy to Put Money Into the Market

Acorns Investing App Makes It Easy to Put Money Into the Market

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I recently came across a new investment app that has become popular over the past year. The app, called Acorns provides a tool that rounds-up a user's debit or credit card purchases and then deposits that money into a portfolio comprised of ETF funds.

I recently came across a new investment app that has become popular over the past year. The app, called Acorns provides a tool that rounds-up a user's debit or credit card purchases and then deposits that money into a portfolio comprised of ETF funds. As an example, if you purchased a $2.67 cup of coffee, Acorns would take an additional $.33 cents out of your account to round the total purchase up to $3.00. The $.33 would then be put into an investment account.

The investment accounts that they provide are a basket of ETF funds that are selected by "a group of engineers mathematicians, and a Nobel-prize winning economist..." The entire investing process is automated, meaning the algorithms automatically choose a diversified basket of ETF funds and rebalance the portfolio when it is deemed necessary. Because it is all automated, the fees are relatively low. Fees are $1 per month for accounts with less than $5,000 or .25%/year for accounts with $5,000 or more in them. This is separate from any fees charged by the ETFs that Acorn chooses, but ETF fees are generally as low as you are going to get.

While the round-up funding method is the one that is most discussed, users can also choose to simply transfer a fixed amount of money into their investment account.

I was a bit skeptical at first but after I watched the video embedded below, I think that they are on to something. If a young person, or even an older person dips their toe into the water by investing round-ups, that removes many of the barriers to getting started as an investor. After all, what generally stops someone from investing is fear and a lack of what to do: how much should I invest, where should I invest, how much should I put in which funds, etc. But Acorns makes it easy for someone to start putting money to work and once this process starts it seems like an easy path to become a life-long saver and investor.

I also agree with one other point mentioned in the video. Financial educators can yell until they are blue in the face that people should start investing, but getting someone to take that first-step is the best way to get introduce them to the practice of savings and investing. Once someone has money in the market, they are much more likely to pay attention and be open to education.

My One Concern

The one concern I have, the reason I haven't signed up yet is security. Acorns is probably safe and I'm sure they have done everything in their power to secure it, but I've seen too many instances where "secure" systems were breached and social security numbers and other sensitive data was stolen. I'm sure Acorns is no less secure than any other major bank or brokerage but still, I feel nervous providing my information over a phone app.

Still, if I can get over this concern, Acorns is something I would be interested in checking out.


Former Fed Chairman Ben Bernanke on Why Interest Rates Are So Low

Former Fed Chairman Ben Bernanke on Why Interest Rates Are So Low

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Former Federal Reserve Chairman Ben Bernanke lifted the curtain on a new Blog he will write and it's already interesting reading for those who follow the interest rate environment. In it, he explains why interest rates are so low and directly addresses critics who have accused him of throwing seniors under the bus by engineering a low savings rate environment.

Former Federal Reserve Chairman Ben Bernanke lifted the curtain on a new Blog he will write (visit the Blog) and it's already interesting reading for those who follow the interest rate environment. In it, he explains why interest rates are so low and directly addresses critics who have accused him of throwing seniors under the bus by engineering a low savings rate environment.

First, the reason that rates are so low. Ben Bernanke explains that the Fed sets interest rates based on an ideal equilibrium rate that is based on the return of capital. In simpler terms, the interest rate is set based on the growth of the economy. If the economy is in recession or growing slowly, then interest rates will be low. If an economy is healthy and expanding, then interest rates will be high. Interest rates have been low for so long because the economy is just not growing very much.

Over the years, many commentators on this site and on other banking sites have complained  that the Fed is killing savers and especially the elderly, who rely on fixed income investments (often CDs) to fund their livelihood. Mr. Bernanke responds to that criticism directly:

" When I was chairman, more than one legislator accused me and my colleagues on the Fed’s policy-setting Federal Open Market Committee of “throwing seniors under the bus” (to use the words of one senator) by keeping interest rates low. The legislators were concerned about retirees living off their savings and able to obtain only very low rates of return on those savings.

I was concerned about those seniors as well. But if the goal was for retirees to enjoy sustainably higher real returns, then the Fed’s raising interest rates prematurely would have been exactly the wrong thing to do. In the weak (but recovering) economy of the past few years, all indications are that the equilibrium real interest rate has been exceptionally low, probably negative. A premature increase in interest rates engineered by the Fed would therefore have likely led after a short time to an economic slowdown and, consequently, lower returns on capital investments. The slowing economy in turn would have forced the Fed to capitulate and reduce market interest rates again. This is hardly a hypothetical scenario: In recent years, several major central banks have prematurely raised interest rates, only to be forced by a worsening economy to backpedal and retract the increases. Ultimately, the best way to improve the returns attainable by savers was to do what the Fed actually did: keep rates low (closer to the low equilibrium rate), so that the economy could recover and more quickly reach the point of producing healthier investment returns."

What he is saying here is that the Fed had no choice but to keep rates low because that is what the economy warranted. The Fed didn't choose the rate, the economy did. If the Fed had raised rates when it wasn't warranted, the economy would have gotten worse and forced the Fed to lower them again for a potentially longer period of time.

He finished with the following statement:

"The state of the economy, not the Fed, is the ultimate determinant of the sustainable level of real returns. This helps explain why real interest rates are low throughout the industrialized world, not just in the United States."

It's hard to argue with this logic. The real pain for savers over the past seven years came from the collapse of the largest housing bubble in history, as well as shifts in technology, trade, and demographics that have put enormous stresses on Western economies. Until Western economies figure out how to stimulate real growth again, the Fed will just be the caboose laying down low rates for the foreseeable future.