Treasuries May Crash, But Shorting Them Isn’t Worth the Risk

jeffrey_matuellaEditor’s Note: The following is a guest post by J. Tyler Matuella.

J. Tyler Matuella is the Publishing Manager at the University of Virginia’s Center for Politics. He also is the author of “Unsustainability in Today’s Sustainable Development” published in Development and Cooperation Magazine, Verge Magazine, and World Review of Science, Technology, and Sustainable Development. He’s majoring in International Business and Accounting at UVa’s McIntire School of Commerce.

Chasing the Next Treasure-y

Everyone has heard about the famed handful of investors-Michael Burry and John Paulson, amongst others-who saw the real estate bubble forming in the early 2000’s and purchased the lucrative credit default swaps to cash-in when the system collapsed. A couple of those investors made billions in a few months from essentially shorting mortgage-backed securities. Now it seems like there’s a new fad on the Street to discover the next bubble and short it, in hope of making record returns. Many of these hungry investors have turned their beady eyes to the U.S. Treasury market.

Record deficits, the European PIGS, and the Greek debt bailout have put sovereign solvency on the short list of investor concerns since the 2008-2009 financial crisis. Even as the world has seemingly recovered from the dark trenches of the crisis with the resurgence of the equity markets, many investors are still waiting for the real bang.

But they’re not just referring to the Eurozone debt turmoil across the pond. There has been a lot of talk recently about shorting U.S. Treasuries right here at home as sentiment about the unsustainability of the debt has reached a fever pitch.

Real Concerns, Real Consequences

The concerns are valid. Some people are worried that the U.S. government’s ballooning debt, coupled with a decreasing demand for Treasuries as the equity markets heat back up, will force the U.S. government’s borrowing rate to rise.

On a more pessimistic note, other investment analysts think that gridlock in the nation’s political system will prevent the government from passing tax hikes and spending cuts that are needed for the government to rein in the debt-the eventual implication is a Greek-like debt crisis. As Treasury Secretary Timothy Geithner warned in early January, “Even a short-term or limited default would have catastrophic economic consequences that would last for decades.”

Perhaps the best case scenario (for the United States, at least) for the fall of Treasury prices is that there’s a compelling argument for significant inflation in the near future. Massive amounts of increased government spending, tax cut extensions, and record low interest rates indicate that the economic system is flooded with cheap, pent-up money that will have to be spent at some point. When that happens, inflation will take charge and Treasury yields will have to jump to continue attracting investors. But at least the inflation will eat away the value of the U.S. national debt.

Small Upside, Large Downside

Short positions are already risky. Such is the case with any investment that has a finite upside and an unlimited downside-(although the downside of shorting Treasuries is not unlimited since most investors won’t accept large negative yields). Treasuries take the risk to a different level, however, and I will explain why it’s nearly impossible to earn a huge profit from simply shorting a bond or using a credit default swap on U.S. debt.

If bond prices fall, theoretically the return from shorting a U.S. Treasury could be anything from a few cents, to the entire value of the bond if the government defaults. To those who are convinced that Treasuries will tank because the insolvency threat is real and coming, then it doesn’t sound like a bad investment.

But there’s a key problem with that logic. Even though it may seem obvious, U.S. debt is denoted in dollars. That’s a critical distinction from Greek or Portuguese debt, which is denoted in a supranational currency-the Euro-rather that their own national currency. If investors are looking to earn landslide profits from a steep fall of Treasury prices because of rampant inflation or government default, then that very situation will correspondingly come with a huge decrease in the purchasing power of the U.S. dollar. Since U.S. debt is denoted in dollars, the purchasing power of that windfall profit from the Treasury short could drastically reduce the real return, depending on the severity of the price drop. There won’t be an opportunity to protect the profit by converting it to a foreign currency because the dollar value will simultaneously drop as the winnings are earned.

Some investors have bought credit default swaps on U.S. debt that pays in Euros. However, the exact same problem occurs in that situation as well. Large per-trade profit margins for retail investors are restricted because foreign banks will charge a premium, around the time of the crash in Treasury prices, to insure U.S. debt because they’re not only dealing with the chance of default, but also the foreign exchange risk. CDS are even more risky since they only pay out in the event of an actual default, and it’s very difficult to imagine that the U.S. government would choose to default instead of just running the printing presses more.

The chart below shows the nature of the restriction of real return per bond if an investor does a “simple” short on a 10-yr bond purchased at $100 face-value :


Is It Still Worth It?

Now that we can see there’s inherently only a small to medium upside to shorting the U.S. Treasuries, the question remains, is that limited potential for gains still worth the risk?

The easy answer is that it depends on investors’ risk tolerance. If you’re a big risk taker or someone with lots of cash like a hedge fund, and if you can afford short term losses and don’t mind earning smaller margins per trade, then go for it. The potential for large absolute gains from making high-volume, small-margin trades still exists on a day-to-day basis without harm to the currency. Investors take advantage of small bond price movements every day. However, as I argued before, any large drop in bond prices will be self-defeating and inherently restricting. The “big bang” of profits that investors found in shorting the real estate market in 2008 simply doesn’t exist in the bond market, in part because of the different nature of the financial instruments used.

To more risk-averse investors, trying to profit by day-trading in the bond market may prove particularly difficult, given the current state of world affairs. If the events in Tunisia and Egypt have taught us anything in the past weeks, it’s that the prices of equities and Treasuries are not governed by purely market forces. Between January 25th and January 30th, investors exited equity positions and fled to the security of U.S. Treasuries amidst fears that turmoil in the Arab world could roil economic growth and pressure oil supplies.

Even with all of the convincing economic evidence for why bond prices should have been falling, bond prices rose for almost a full week while equities fell. Once investors realized their fears had no economic grounding, bond prices fell back and equities returned to normal. If someone shorted bonds that week, they would have lost a lot of money-the problem is that every economic model in the world couldn’t predict what happened in Egypt.

A Riskier Way to Short the Treasury Market

For small-cap retail investors who are certain that bond prices will fall in the coming months, there’s an alternative to take advantage of the fall in bond prices and still earn a huge return without the currency risk. Some inverse U.S. Treasury ETFs, such as the Horizons BetaPro U.S. 30-Year Bond Bear Plus ETF (HTD), allow investors to use leverage to short the U.S. bond market. This ETF is denominated in Canadian dollars, and it hedges against exposure to the U.S. dollar every day. As long as the investor considers the denominated currency’s home country to be “debt-stable,” then this investment avenue effectively reduces the currency risk.

However, there are some salient problems with investing in inverse ETFs-especially levered ones-from a risk-return standpoint. The returns on a daily basis of HTD, for example, range from +200% to -200% because of the leverage. As a result, holding onto these types of funds for more than a few days can be deadly. Treasury prices may fall for four straight days, earning the inverse ETF investors massive returns with leverage, but only one or two days of small to medium-sized losses later can negate multiple days’ gains, even to the point where the net return on investment is negative. While market fundamentals exhibit compelling evidence for why Treasuries should consistently fall, a little political turmoil around the world could cause Treasuries to rise again short-term and severely hamper the returns from inverse ETFs. Since investors really shouldn’t hold onto these levered inverse ETFs for more than a few days at a time because of the compounding high risk of doing so, investors will have to keenly get into them just before the debt crisis in order to earn massive returns-that is, if a U.S. debt crisis occurs at all.

If You Do It, Do It Right

Going short on bonds probably isn’t the best way to take advantage of a debt downgrade or rising inflation in the U.S. vis-à-vis going long on metals. But for investors who insist on taking the risk, the best way that I have heard to do so is to short the bond, take the money gained from the sale of the borrowed bond, and immediately put it in a forex Euro futures contract. That way, the investor locks in the exchange rate and preserves the purchasing power of the initial investment. Even if the dollar greatly depreciates in the meantime, the investor will still walk away with a solid gain. Depending on how far the bond price falls, the investor could still earn 60-70% per trade, though that size return is highly unlikely. In addition, the risk of betting against the world’s reserve currency over the course of an entire yearlong contract makes it an even riskier position, and perhaps more apparent why shorting Treasuries may not be worth the risk.

Playing the Game Requires Knowing the Risks

The dollar still holds strong as the world’s reserve currency, which could prove an obstacle in the future to investors who short bonds amidst political turmoil in the Middle East. And since large profits (per trade) from shorting bonds are very unlikely even in the event of a debt crisis, it doesn’t make sense for most small-cap, retail investors to play the high risk, low return game that characterizes the bond market. However, for those who insist on profiting from shorting the potential debt crisis in the United States, doing a regular short and putting the initial payout in a forex Euro futures contract may be the best way to produce solid returns with minimal currency risk.

Inflation: A Reason for (Not) Investing in Bonds

Most people invest in bonds because they want to have stable fixed income. Because the performance of bonds are very stable, they also serve to reduce the volatility of the overall portfolio. Depending on the weighting from 0% to 100%, you can reduce your stock volatility correspondingly. With regular re-balancing between your stocks and bonds, you should be able to “sell high and buy low” in your stock portfolio, and use your bonds as a stable source of income.

Everything sounds good so far, but the most attractive feature of fixed income is also its greatest drawback — the income is FIXED. It does NOT increase as time goes on, and inflation keeps reducing your principle and interests into nothingness. Since inflation is almost always there, you’ve got a real problem especially when you’re investing long term in long term bonds.

Normally, this problem is resolved through obtaining higher interest yield on your bonds to compensate for your inflation risk. Assuming that your obtained yield is always higher than the inflation rate, you will not have a problem. Your actual income from bonds however should be on an after-inflation basis, and after-tax for that matter.

Vice versa, if the economy is undergoing a phase of deflation (usually caused by economic recession or depression), it is very advantageous to invest in bonds. Not only do you get a fixed income while everything is falling off the cliff, but the purchasing power of your principle just keeps getting better. From 1980 to 2001, the US and the world in general experienced one of the most prosperous economic eras. During that period, the nominal inflation rate was relatively low while the economic expansion kept going strong.

In the spring of 1980, when Fed Chairman Volker hiked interest rate to stratospheric a 15% in an attempt to save the dollar from further depreciation and to put a stop on double digits inflation rate, it was actually close to the peak of inflation. When interest rates peaked, bond prices were low (interest rate increases lead to lower bond prices) and created an excellent opporunity to invest in bonds. At that time, if you had invested in bonds, you could have locked in some 10% to 15% annual yield rate for the length of the bond you purchased (like 30 year treasury bonds).

Bond Yield History from
Source: Yahoo! Finance

After an almost 20 year bull market in bonds, I personally believe that we are embarking an era where the inflation rate is heightening (at least in the US), which will force bond interest rates to stay high if not go higher. I encourage you to study the inflation chart from, a great site for historical data research, to gain some historical background. I also believe that in coming years bonds are probably not the best investment because of the huge debt overhang on the US dollar.

Bond Hedges
If you’re interested in playing against a bond bear market, one can actually “short bonds” by borrowing a big amount from a fixed term loan, such as home mortgage. Assuming that bonds are not a good investment, “shorting bonds” by having a mortgage will work to your advantage by essentially reducing your real payments over time because of higher inflation.

A riskier hedge against bonds is to invest in gold & silver and natural resources. In any case, I would suggest that instead of investing your money in bonds which generate a fixed income, you should probably invest into a dividend-paying stock, preferably one who ties its dividends to the price of natural resources. Yes, it may be more volitile, but in the long term your dividends can keep pace with inflation and the price of the natural resources. Here is a list of high yield dividend stocks, yield from 6%+ to almost 20%, mostly tying their dividends to price of gas/oil, or its related business.

TIPS are for waiters?
Protection of your inflation-adjusted principle is the most important thing in investing. There are times when investing in bonds is wise, but now is probably not one of those times. You may argue your case for investing in TIPS, treasury inflation-protected securities which have interest yields indexed to CPI. But I cannot trust a Fed that hides M3 money statistics, nor a government that uses hedonic adjustments on CPI to bail you out of inflation. Plus income from TIPS is taxed, so even if your initial income is inflation-adjusted, taxes will take their toll.

More Bond Resources
For more resources on investing in bonds, check out Chris’ article What are Bonds? here on InvestorGeeks. I’ve also posted a series of articles on bonds on my site 1stMillionAt33:

  1. Intro to Investing in Bonds: Fundamentals
  2. Intro to Investing in Bonds: How-to
  3. Intro to Investing in Bonds: Risk Factors
  4. Reasons for (Not) Investing in Bonds

A Buck, A Yen, A Mark or A Pound

Devaluation of currency is not uncommon in other countries, but so far has been moderate in the U.S (in part because the dollar is the world’s currency). I recently discussed this in an article titled Speculating on the Future of the Dollar. But given our massive debt, budget deficit and trade deficit, a significant drop of the dollar against other world currencies (and corresponding increase in inflation as all types of imports become more expensive) becomes a possibility.

How can you protect your portfolio from a significant slide in the dollar?
This is indeed a tough question, and I won’t claim to know the answer. However, based on what we’ve seen in other countries, when the value of a currency drops, the value of tangible assets remains roughly the same. In other words, devaluation and inflation go hand in hand.

The consequences for traditional investment vehicles are tough to predict. A value investor might say that stock prices would rise, especially for multinational companies that have significant non-dollar assets. But the stock market is.. a market. And if people are withdrawing money from their mutual funds to cover increased expenses, stock prices will drop regardless of the valuation of individual companies. The same applies at least in part to real estate, though again there are many other factors involved.

In short, you can’t count on stocks, real estate, mutual funds, or certainly dollar denominated or corporate bond funds to protect you from inflation.

So what are your options?

One is TIPS (Treasury Inflation Protected Bonds), that pay a base interest rate and a correction value based on the consumer price index (CPI). Not a bad approach, though there are risks involved for those who are more on the paranoid side – namely, you are trusting the government to accurately calculate the CPI and meet it’s payment commitments on the bonds.

Another traditional approach is gold. Gold is easier to invest in than ever now that you can purchase gold funds (one popular one is GLD). There are two problems with investing in gold. First, it really is a speculative investment – in other words, the price of gold seems more dependent on the action of speculators and governments than on currency values. Second, gold is a rather poor hedge against inflation. If you bought gold at $130/oz in 1975 and sold it at $600 last month, your overall return would be 5.06%, vs. an inflation rate of 4.63% for the same period. Gold might still be a good protective choice (especially if you are concerned about a worldwide depression including a collapse of all currencies, not just the dollar), but as an investment it’s not a particularly good long term play. Gold is also generally taxed as a commodity, not an investment – so you get to pay taxes at the regular rate – which wipes out much of the protection it offers.

You can trade in currency futures. This is just like trading option on the stock market – a technique for more sophisticated investors. I’ve actually done a bit of this, but more as a hedge to prevent a sudden increase of costs when traveling abroad. Currency futures suffer from the same problem as options – they expire. If you’re concerned about a drop in the dollar in the next few months, futures are a great deal. But if you’re concerned about a drop in the dollar over the next 20 years, they are an expensive form of insurance.

A newer approach involves currency ETFs (Exchange Traded Funds). These are funds that hold other currencies. You can now buy ETFs in Euros, Pounds and other major currencies (and a few relatively minor ones). These are especially nice if you’re in the U.S. where it’s typically difficult to trade in other currencies. Their disadvantage is that they really are a pure currency play. The currency in the funds is typically held in accounts that pay little or no interest, so you’re lucky if the fund’s income pays for the fund’s expenses. Another disadvantage is that the IRS considers these a form of commodity trading, and any gains are again taxed as regular income.

Finally, you can invest in an international bond fund. This is my personal favorite. Because the fund’s holdings are generally not in dollars, the fund will tend to do better when the dollar is weakening. At the same time, the fund holds bonds that actually do pay interest – so the fund has income that offsets both expenses and loss in value due to fluctuating interest and currency exchange rates. As a result, you have potentially the best of both worlds – an income fund that at the same time provides protection from a significant drop in the dollar. More important, depending on the individual fund, some of its return will be in the form of long term capital gains (with its more favorable tax rate). Plus, if you hold the fund for over a year and it increases in value, your profits will be taxed at the long term rate when you sell. There is risk – bond values drop as interest rates rise, so I would definitely stick with a short or intermediate term fund if you go that route.

Currency and gold ETF’s are the latest cool investment toy on the block, but frankly, I’m not impressed. Consider using a currency ETF if you’re planning a trip abroad and want to protect yourself from currency fluctuations. Consider a gold ETF for your IRA where the taxation rate isn’t a key factor. But at this time, for a good balance of income and security from a drop in the dollar, a short or intermediate term international bond fund might be just the ticket.

The Importance of a Mentor

Becoming wealthy is a full-time job. Successful entrepreneurs have worked for years to build a deep knowledge base in areas as diverse as sales, marketing, accounting, stock investing, real estate investing, leadership, team building and personal finance. For someone who is still laying his foundation, finding a mentor can help him avoid potholes he otherwise would not have seen, and is an invaluable asset as both a friend and a counselor.

A mentor is someone who has already done what you have set out to do. Whether that means becoming a successful stock investor, or real estate mogul, your mentor is an expert and is willing to share his experiences. Just as professional baseball players have pitching coaches and managers have leadership coaches, so should budding entrepreneurs have a mentor that can help steer them down the right path.

While mentors or coaches can be found in various fields for a fee, it is vitally important that your mentor is actively involved in their field, and truly wants you to succeed. Financial planners and stock brokers can work for a commission, and may not actively invest in the products they sell you. Therefore these would be poor mentors. While their professional opinions may be extremely valuable, they may not always have your best interests in mind.

Unfortunately, finding a mentor can be easier said than done, but networking is likely the best way to find someone you can trust. So join an investment club or networking group; talk to family members and friends. Those that keep their eyes open will eventually find someone who not only shares their passion for the field but also is interested in spending time with someone just starting out.

How to Get Started: The Basics

In my last article, I discussed starting my portfolio, and a strategy for allocating assets efficiently while keeping the number of accounts and fees manageable. As I stated in that article I think it’s very important for those of us who want to eventually become more involved with individual stock investing to have only a small portion of our funds in a brokerage account. Because we’re very inexperienced, risking too much of our portfolio with individual stocks can leave us open to a lot of unnecessary risk. That’s why I advocate starting simply by learning the basics then building a foundation of a few stock and bond mutual funds, before allocating more to individual stocks.

This strategy may not be exciting, but to paraphrase Ben Graham, author of The Intelligent Investor, true investing should be boring. By learning the basics we can understand the full range of investments available and how to maximize their returns. We can then invest in relatively safe but consistently well-performing mutual funds. Not only do mutual funds provide instant diversification, but they also give us focus as we continue to learn about more advanced investing topics. As I will mention again, we have a lot to worry about when we’re just starting out. There’s no need to add risky investments to that list before we’re ready.

First, Get the Basics
There’s a lot to learn when we’re just starting out. Even seemingly simple things such as terminology and market basics can become overwhelming. In my view, before we can successfully invest in stocks, we really have to invest in and fully understand all the less risky investments. By learning the basics first, when the next bear market occurs or a sector takes a nose dive, we’ll be able to understand what we have to fall back on as we regroup. Additionally, it is important to diversify our portfolios to counterweight our domestic stock investments. Although this may reduce overall performance, it also allows for greater consistency each year and reduced likelihood of real asset loss (3% growth or less) — especially as we’re just starting out.

I think of this critical beginning stage of investing like when we begin a new diet or workout routine. We’re very motivated to get started, and we want to see results right away. So we starve ourselves and workout 3 hours a day, and after a month we’re so tired and burned out that we fall off the bandwagon. We forget that we need to first get ourselves into healthy habits such as dedicating 4 hours a week to exercise, and eating smaller portions of food, before we really can kick into full gear. Just like a car’s engine, accelerating slower always leads to a longer healthier life.

So before we invest in mutual funds we have to get the basics. I’m getting my basics from a number of books and web sites right now. Here’s a list of the best materials I’ve found…

Second, Create a Plan
Few wars were ever won without a strategy and few investors will get rich without one either. Creating a plan as to how we want to allocate our assets will help guide us throughout the years, and keep us focused on our goals. Just getting started, though, we don’t have a lot of money to throw around and fully diversify. Being smart about what our long term goals are and our investment horizon will help with that. As a younger investor, I’m looking at a mix of index funds and highly rated but more risky funds with greater overall performance. Don’t worry if your plan is very simple, we’re just starting out. A simple strategy is best for a simple portfolio. Here’s a sample portfolio strategy:

75% stock funds
10% bond funds
15% brokerage account

Within each group, I can then figure out if they should be in my tax-deferred accounts or my taxable accounts, and what kinds of funds are best suited for me. For example, in my case I want my bond funds in my tax-deferred IRA account so that I don’t whacked with taxes because of income distributions. If you have a serious nest egg (over $100,000) to start with, it may also make sense to get a second opinion on your strategy from a financial planner. Some planners offer this service without a long-term commitment for under $500.

Finally, Do Your Homework
Now that we’ve learned the basics and we know how we want our assets divided, it’s time to pick our mutual funds. I personally started with my bond mutual funds then went to stock mutual funds, but you can do it however you feel most comfortable. When selecting mutual funds, it’s important to follow the advice of experts around the web and look for highly rated funds with performance better than the benchmark, a sound investment strategy, good management, low expenses, and blessings from the analyst community. If you can earn consistent returns with a trusted company when you’re starting out, you’ll save yourself many headaches and free your time up to learn more about other things.

Finding high quality tools is also extermely important, because finding good investment ideas is hard work, and a few good tools helps lighten the load. For my non-401(k) porfolio, I selected a handful of stock and bond mutual funds by using the Morningstar’s Premium Fund Screener, and then got additional information from Reuter’s Lipper Research Center, the funds’ prospecti, and the funds’ shareholder reports from the last 4 quarters. You can find more information on how to use the Morningstar Premium Fund Screener in my two-part series on this site.

Doing your homework is the most important part of this entire process in my opinion. Investing is more than anything a research activity. Starting now to do your homework will help show you if you are destined to become a defensive investor or an enterprising investor. Those who are willing and able to put in the research time can become enterprising investors; those who do not, should stick to funds — if you think picking a few mutual funds is hard, wait till you have to pick a dozen or so underpriced companies.

Wrapping it up
Getting started is hard enough. Keeping your first investment strategy simple will help you save time to learn about more advanced topics such as individual stock investing. A simple asset allocation strategy and selecting a few high quality mutual funds seems to me to be the best strategy for the new investor. And remember, if you have questions or want to talk to someone, not only are resources available online such as user groups, but financial advisors can also help with one-time consultations to keep you on the right track.

2-year Bond Yield Higher than 10-year

I woke up this morning wanting to answer one question more than any other. Why is the yield on a 2-year bond (4.37%) higher than the 10-year yield of 4.35%? [1]

After some research, I have to admit I’m still a little lost. Understanding how our economy runs is not my strong suit (you’d be better off reading Chris’s posts). But I’ll take a stab at this.

Economists call what’s happening in the bond market an inverted yield curve2. The fact that we are seeing one now is cause for concern. From Investopedia:

Historically, inversions of the yield curve have preceded many of the U.S. recessions. Due to this historical correlation, the yield curve is often seen as an accurate forecast of the turning points of the business cycle. A recent example is when the U.S. Treasury yield curve inverted in 2000 just before the U.S. equity markets collapsed. An inverse yield curve predicts lower interest rates in the future as longer-term bonds are being demanded, sending the yields down.

That’s pretty scary stuff. If you’re looking for a reason to remain bullish, a Morning Star Bond Report3 had this to say:

Some economists continue to eye the yield curve as a daily economic indicator. Others question its utility, saying special factors, such as the government shifting issuance to shorter maturities, have distorted the curve’s telling powers.

So I’m not sure if I should be scared or not, but we still don’t know WHY the curve got inverted in the first place. The “why” in all of this would seem to be important. John Rutledge tries to sum things up this way (emphasis mine)4:

1. An inverted yield curve is not the end of the world. The last 4 recessions have all been preceded by inverted yield curves, but that does not mean that an inverted yield curve always implies a recession.
2. The important thing is why the yield curve is inverted. If the yield curve is inverted because the Fed has just forced a sharp increase in short rates (like 1980-81) you may have a problem. If it inverted because long rates have been easing lower to reflect moderating inflation worries (like today) it might be fine.
3. The anchor on inflation today is Chinese and Indian wage and prices. It makes sense for investors to expect low inflation in future years.
4. Either way, the condition is likely to be temporary because inflation is not likely to fall forever. It could be resolved next year by the Fed backing away from tightening short rates to keep bank reserves growing. Or it could be resolved by a major bankruptcy (GM? Ford?) which would push the Fed away from tightening.
5. Implication: in a world where the Fed is targeting prices, it is not appropriate to view them as an exogenous driver of the economy. Their behavior will adapt to outside influences on prices, e.g., oil prices, price and wage differentials, and technology changes.
6. The economy is growing, inflation is low, and profits are increasing at double digit rates. This is a great time to buy stocks. If people get spooked by the inverted yield curve and prices fall, buy more equities.

Ok, so our yield curve is inverted because long-term rates have been dropping (or in reality lagging behind short-term rates as the Fed hikes interest rates) “to reflect moderating inflation worries”. We’d only have to worry if the inversion was due to short-term rates increasing. Ahhhh.

I liked Katie Benner’s take over at CNN Money. Benner writes that a gradually flattening curve isn’t worrisome in itself, which is what we have now with the difference between 2-year and 10-year rates tightening by 10-15 basis points per month. Benner quotes Anthony Crescenzi who says, “It is when the pace becomes much faster than 15 basis points a month that investors should start to worry.” [5]

Hopefully this will help you understand what those folks on the TV are talking about. I’m interested in hear your thoughts.

[1] Bloomberg Rates and Bonds.
[2] Investopedia Article on Inverted Yield Curves.
[3] BOND REPORT: Treasurys End Higher, Yield Curve Flattens After Data.
[4] Inverted Yield Curve by Dr. John Rutledge.
[5] Too fast, too soft… investor beware by Katie Benner.

What are Bonds?

In The Intelligent Investor, Benjamin Graham encourages investors to divide their holdings among two broad types of investment: bonds and stocks. He recommends dividing an investors’ portfolio between them from 25% to 75%, depending on the investors’ financial goals. Because stocks provide all the glitz and glamour of Hollywood the most investors understand how they work (or at least they think so). However, bonds are the ugly understudy and as a result can be misunderstood.

Because bonds are supposed to play such an important role in our portfolios, this series of articles on bonds will take us through the basics of bonds, describe the type of bonds available, provide links to resources and lay the groundwork for us to begin investing in them. To begin the series we’ll start at the beginning: what are bonds? We’ll go over what they are, how they make money, and basic pricing considerations.

In general terms, bonds are loans in the form of securities. They are offered by organizations like corporations and governments as a way to raise money by selling “shares” of a large loan to many groups and individuals. The two basic ways to purchase bonds are similar to stocks. An investor can build a custom portfolio or he can purchase a bond fund. One of the nice features of bonds is that you can sometimes buy directly from the bond issuer. For example, the Bureau of Public Debt setup TreasuryDirect as a way to sell U.S. Treasuries directly to the public, commission-free. For most other bond purchases, bonds can also be obtained from full-service brokerages and bond brokers for a commission.

Instead of buying individual bonds, they can also be purchased through mutual funds. The bond fund can be a convenient alternative to building a portfolio because the world of bonds can seem complicated and intimidating. This is primarily because of how many different types of bonds there are. However, there are benefits for the intrepid investor who can devote time to selecting the appropriate bonds to meet his needs, such as higher returns, and greater tax benefits.

The basic way an investor makes money on bonds is by earning interest. A bond’s “coupon” is basically its interest rate. The coupon’s name derives from the time when an investor would tear off a paper coupon from the bond in order to receive his interest payment. At 6.0%, one would earn $60 a year (typically in semi-annual payments) on a $1000 bond which would be paid until the bond matures and is bought back by the issuing organization.

The real world is more involved, though. After bonds are initially offered to the public (think IPO) their price can change. You could, in fact, buy a $1,000 bond for $900 or $1,100. In bond parlance, a bond price that is lower than the face value is called a “Discount”, while a price greater than the face value is called a “Premium”. Factors such as credit worthiness, time until maturity, and prevailing interest rates can all affect bond prices. The great thing about bond prices though is that interest is calculated based on their face value, so a bond can actually be earning interest off of $1,000 even if it costs only $900. This increases the effective interest rate, which is called “Yield”. Simple yield is calculated by the formula: Coupon / Price.

Of course, even yield is not so simple. When advanced investors refer to yield they’re actually referring to the yield to maturity (YTM), which is apparently a very complicated formula that I have not yet seen. This gives a truer picture of the actual rate of return for a bond and should be looked at first and foremost.

In summary, bonds are securities like stocks except that instead of being shares of a company, they are shares of debt. Investors earn money from bonds through interest payments, called coupons, but the effective interest rate changes based on the price of the bond, which is determined by our good friends, supply and demand. Finally, bonds can be purchased at full-service brokerages, and bond brokers.

To learn even more about bonds, take the action steps below and read the very good articles on bonds at Investopedia, and also look at the 100 level courses at the Morningstar Classroom.

Action Steps
[1] Read “Bond Basics” at Investopedia
[2] Take the free 100 level bond courses at the Morningstar Investing Classroom.
[3] Read more about bond funds at Investopedia

Additional References
“Bond.” Wikipedia. Dec 19, 2005.

The Importance of Buying What You Know

Frank, Jason and I were having dinner this past Saturday and we were discussing future markets. Jason brought up Biotech and was talking about some of the possibilities for future advances, and how they may affect the industry. Now, Biotech is something I know very little about — in fact, I know almost nothing about it. As a result I probably am not going to invest in Biotech in the near future.

One of the things a savvy investor must do is understand his own strengths. In the words of Sun Tzu, “Know your enemy, know yourself.” In many cases, you are your own worst enemy. When looking for new investments in either stocks or bonds or any other type of security, you should have a high level confidence in what you are investing in. Each investment has its own risks and challenges and fully understanding them will prepare you in case of unexpected events. For example, factors affecting bonds include changing interest rates, yields, and term; for stocks gaining a basic understanding of how the company functions and how it is performing internally is required background research.

When faced with the option to purchase stock from a company whose industry is abstract and foreign to you, it may be worth passing it up. As an illustration, I work in technology, and as a result I stay relatively up to speed on current events in technology and technology related companies. I’m also in a technical position so I understand the technology behind the news. That makes it relatively easy for me to sniff out hype from real growth. However, I never hear anything about copper mines, who buys copper or even who makes copper. As a result, I would need to read up on the natural resources industry, and pass up on investments in that industry until I do.

And don’t be so trusting of everything you read because hype comes from everywhere. I often see articles about tech companies in SmartMoney that are full of more hot air than real substance. This is not to say that the writers at SmartMoney are devious and should not be trusted. Companies have trained marketing staffs waiting for the ear of financial reporters and pundits. A little salesmanship on the part of the company, and a little excitement on the part of the writer, and puffed up articles are never far behind. Writers are not to blame, these things happen to all of us; all it means is that writers are humans too and we need to do our own homework before making an investment decision.

There are many, many companies out there in many different industries. In fact, the market is divided into 12 large groups called “sectors.” These range from terms like “Financial” to “Consumer/Non-cyclical.” Inside these sectors are “industries” such as “Investment Services” and “Personal & Household Products.” With all these choices, it is best to stick with industries and sectors that you have frequent interaction with, or that you understand on a deep level.

Some examples of suitable industries for you may encounter every day include Restaurants, Grocery Stores, Consumer Goods, Entertainment. In addition, your job or hobbies may place you in contact with additional industries which should be added to the list. By sticking with what you know, you’ll be able to spot hidden traps while you’re analyzing a possible new investment, potentially saving you from heavy loses or underperformance.