You Are About to Get Killed in Bonds

You Are About to Get Killed in Bonds

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Many investors, commentators and financial managers have perpetuated and subscribed to the fiction that those who want to protect themselves from an overvalued stock market should be moving to bonds.  In fact, a recent New York Times piece, described here, even mistakenly assumed described investors’ choices as being binary – stocks versus bonds.

The idea that bonds are somehow a safe investment comes from the fact that long-term bonds have appreciated dramatically over the last several years as interest rates have come down and expectations of their rising have diminished.  

With the 10-year Treasury yielding 2.10% and with the Federal Reserve guiding towards a Fed Funds rate of 3% in 2019, I would argue that the only way long-term interest rates do not rise, and rise dramatically, is if we fall into an economic depression and the yield curve becomes inverted.   Also, oil and commodity prices are currently tremendously suppressed because the monarchy’s policy of opening up reserves is causing too much supply to reach markets.  An impeachment trial will change this, causing commodity prices and inflationary pressure to rise, and driving 10-year Treasury rates to levels that those in their 20s and 30s have never seen.

The impact of a turn in interest rates on bond prices will be dramatic.   You can ask anyone who tried to sell a long-term bond in 1970’s how many pennies on the dollar they received for it.  Alternatively, you can speak to anyone who bought a long-term bond in July 2012 when the 10-year Treasury was at 1.52% how much their brokerage account valued it in August 2013 when the 10-year Treasury was at 2.90%.  Bond investors can quickly lose 30% to 50% of their principal should they need liquidity during a period of rising interest rates.

My view that another dramatic move up in 10-year Treasury yields – and dramatic fall in bond prices – is likely upon us is not unique.   It is shared by Leon Cooperman and Alan Greenspan.

Your safety is found in savings accounts and short-term CDs.


Portfolio Drift

Portfolio Drift

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While Donald Trump has certainly caused concern to some over his style and actions as President, few have been anything but jubilant over the impressive rise in the stock market since January.   Actually, if one looks back to late 2008 when the market dropped 37%, we have all since enjoyed a spectacular ride up between then and now of around 300%. 

There was a very interesting, recent article in the Business Section of the New York Times on one very important aspect of the huge rise since 2008 – portfolio drift - and the related implications for everyone in the market at this time. Obviously, one of the implications is that those of us in the market during some or all of that time have enjoyed handsome appreciation of stock assets and, by implication, feel ever more comfortable financially.  But the Times’ article points to a related and worrisome impact of the steep rise in the markets to which most of us probably have not paid as much heed as we should have.  And that is the relationship or portfolio mix between safe assets, like cash and CDs, and far more volatile stocks.   (Actually, the Times articles speaks of bonds as a safe investment which is a serious error – bonds are especially likely to decline in value as much if not more than stocks as interest rates rise.)  Most of us who own stocks balance our risk by also owning CDs and cash and, by so doing, ensuring that our investments are at least somewhat protected by the lower volatility of these reserves in the event of another large drop in the stock market.

But by now, given the huge increase in the stock market over the last eight years, the balance between stocks and cash and CDs in our portfolios, if we have not been paying attention, has shifted considerably.  As the Times points out, an allocation of 60% stocks in 2008 would be far more likely – if no cash reserves were added – to be around 75% stocks.  And this kind of allocation is risky for all but the most daring among us.  Yet, this is also likely where most of us are at this moment.

And, that is not a good place to be under the best of circumstances.  And, we are not anywhere near the best of circumstances at this moment in the nation’s history.  In fact, it is hard to imagine a more vulnerable time for the market than right now – given all that is happening in the U.S. polity.  The Times’ article is a clarion call to action, but one, I bet, few will act on.  The market has just been too good for too long, and most of us, present company included, can’t wrap our minds around how volatile things are now and how likely it is that we will have a serious decline in the market in the weeks if not days ahead. 

It is time to get our heads around the dangers ahead.  Those who do, and who at least rebalance assets in favor of cash and CDs in light of portfolio drift, will be in a far better position to weather the storm we are absolutely going to have in the very near future.

See the best 1-year CD rates here.


Goldman Sachs Comes to Market with a 6% Structured Note

Goldman Sachs Comes to Market with a 6% Structured Note

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I have written about structured notes before on BestCashCow.   I believe that they may represent a good way to generate income in a fairly low-risk way over time at rates well above the rates offered by savings and CDs.   Or maybe not.  Under any circumstance, they only work for a certain type of investor.  It is easy to get drawn to high yielding instruments after yields of extraordinarily low savings and CD yields.  Yet, these will be inappropriate for most people seeking more yield as they go out for 15-years and may be very illiquid for most of that time. 

What I particularly like about these instruments is that they are generally geared to deliver large interest payments as the long end of interest rate curve rises, unlike bonds and municipal bonds, which will see a strong and pronounced losses of value in 2018 and 2019 and beyond if the Fed continues with its stated plan to raise interest rates.

A common structure in structured notes involves a 15-year period during which the notes pay interest tied to the spread between the 30-year and the 2-year Constant maturity swap rates (“CMS”).   CMS is a rate at which bank’s trade with each other, and basically involves the difference between the stated maturity’s equivalent US Treasury rate and the 6-month US Treasury rate.  The 2-year CMS rate is currently around 1.60% while the 30-year CMW rate is currently around 2.60%.  The spread is currently at around 1%.  (If you don’t have access to a Bloomberg, these rates can usually be found here).

If rates on the long end go up faster than the short end, the spread will widen.  If they go down, it will contract or go negative.   If they spread goes negative, the holder if these instruments foregoes interest.  If the S&P falls by more than 70% from where it is on the pricing date, the holder also forego interest.  With this note, you win if the stock market doesn’t completely crash from the date of issue and the long end of the yield curve goes up.  

Over the last several years, this structure has outperformed savings and CDs, but hasn’t been a big winner since long rates haven’t meaningfully gone up.   Since holders sometimes require liquidity, it has been possible to buy notes on the secondary markets at a significant discount to par.

This offering by GS Finance Corp. is guaranteed by The Goldman Sachs Group and follows this same structure generally.  It pays a fixed rate of 6% in the first year, but unlike most other offerings it pays 6x the spread (most other offerings pay only 4x or 5x).  It is also attractive as the maximum interest rate is capped at 12%  (whereas most Morgan Stanley, JP Morgan and Citibank offerings in the past have been capped at 9% or 10%).   If you buy these notes today, you are hoping that the higher multiple and higher cap will prevent them from trading at a significant discount to par should you require liquidity over the next 15 years.

There is no doubt, the Goldman product is interesting and Goldman is a great credit.  But, anyone investing in these products needs to understand that a product of this length is going to involve real liquidity risk and the real risk of no interest payments for a lengthy period of time.  There are other risk too, detailed in this article.

These notes way be worth a look, but I would continue to have a strong bias towards savings accounts and CDs.  You’ll find the best savings rates here and the best CD rates here.

Editor’s Note: The product discussed above trades under CUSIP 40054LLP7 and ISIN US40054LLP75.   It is offered principally through investment advisors.   BestCashCow does not believe that the product is appropriate for most investors, and does not endorse it.