Bond investing during turbulent economic conditions

By Seth Hammer, CPA, Ph.D.

Advisors who seek to maintain some stability within their clients' portfolios through the use of bonds face greater-than-normal challenges during this ongoing period of uncertain and turbulent economic conditions.

While bonds (other than high-yield bonds) traditionally could be relied upon to reduce risk and volatility, their potential effectiveness has become less reliable, largely because of the confluence of three factors:

a high federal budget deficit,
a weak U.S. dollar, and
a likelihood of "measured"¹ increases in interest rates from their historically low levels.

This article will attempt to provide a brief overview of the interaction of these factors and offer some strategies for hedging fixed-income investment risk through the use of foreign bonds / bond funds and Treasury-Inflation Protection Securities (TIPs).

While the budget deficit for 2004 is expected to exceed $500 billion, interest rates through 2003 and the early part of the year have remained near historically low levels. For example, 10-year T-notes on May 10 were yielding 4.8 percent and six-month T-bills were yielding just 1.34 percent.

Despite the record-high deficits and, in contradiction of recent empirical research that suggests that deficits do affect bond yields,² interest rate increases have been relatively modest. A potential explanation for this contradiction (and one that adds considerable uncertainty for the future level of interest rates) is that foreign nations have been supporting the U.S. dollar in order to maintain the strength of their own economies. One example is the Bank of Japan, which in January spent $67 billion, much of it recycled into U.S. Treasuries, to support the dollar as a means of keeping its exports affordable to purchasers using U.S. dollars.³

A potentially significant risk related to foreign support of the dollar is that such support may be withdrawn suddenly and without warning, should those purchasers (e.g., the Bank of Japan) determine that maintaining the value of the U.S. dollar is no longer in their best interests. A sudden withdrawal of foreign investment in U.S. Treasuries could potentially lead to increases in their yields while saddling existing fixed-income investors with losses in the value of their holdings.

A further risk for existing fixed-income investors is that Federal Reserve Chair Alan Greenspan has already said there will likely be "measured" increases in interest rates, which could lead to further erosion in the value of bonds. The actual future effect is far from certain, however, since there already has already been some decline in bond prices following his comments.

Advisors seeking to hedge their clients' risks under these conditions of uncertainty may wish to consider the following alternatives:

Foreign bonds and / or unhedged foreign bond funds

Investments in foreign bonds or unhedged foreign bond funds will generate income in cases where the value of the dollar declines relative to the currency of the foreign bond, because the investor's funds are held in the foreign (rather than U.S.) monetary unit. Of course, if the dollar should increase in value, the opposite effect will occur. Clients, therefore, should be reminded of the nature of hedging strategies (i.e., protection against major setbacks comes with costs).

There is a caveat: Investments in emerging market bonds (as opposed to those from more developed countries) may actually increase risk, rather than reduce it. One reason for this is that the prospects for countries categorized as emerging markets are generally considered to be more susceptible to worldwide tightening of credit than are developed countries.

Treasury-Investment Protection Securities (TIPs)

Treasury inflation-adjusted investments offer the primary benefit of ongoing protection against inflation and, secondarily, an exemption from state-taxation. The latter is often a significant consideration in states with high state and local tax rates, such as Maryland. These investments are, however, subject to federal taxation and therefore are most advantageously held in a tax-exempt account.

An additional, soon-to-be-available benefit of TIPs is that they will be offered in five-year terms, providing investors with opportunities to hedge against the risk of inflation, without the long-term commitment and related risk of a longer term bond. While the interest rates are currently low (e.g., 2 percent for TIPs due Jan. 15, 2004), these investments could provide a very valuable portfolio hedge, should there be a significant increase in inflation.

Other considerations

U.S. government I-bonds may be a viable alternative to TIPs in cases where the investments are to be held in taxable accounts. I-bonds may offer slightly lower returns but (unlike TIPs) provide opportunities to defer recognition of income for as long as 30 years.

Closed-end municipal bond funds, employing leverage, should generally be avoided during periods of rising interest rates. These funds often borrow money at short-term rates to acquire long-term municipal bonds. While such strategies have provided excellent returns during periods of low short-term interest rates, they could backfire should there be a significant increase in those rates.⁴

Seth Hammer, CPA, Ph.D., is an accounting professor at Towson University.

Footnotes

1. "Greenspan Sees Economic Danger in Budget Deficit," by Greg Ip, The Wall Street Journal, May 7, 2004, A2.

2. "Budget Deficits and Real Interest Rates: Updated Empirical Interest on Causality," by Richard Cebula, Atlantic Economic Journal, September 2003, pp. 255-265.

3. Weak Dollar Keeps Rewarding U.S. Bond Market," by Brian Blackstone, The Wall Street Journal, Feb. 10, 2004.

4. "Don't Get Burned by these Bonds," by Steven T. Goldberg, Kiplinger's Personal Finance, September 2003, p. 52.

This content has not yet been Rated.

To Rate content, please Login.