Lend Money To Uncle Sam?

This week I was in the Doctor’s office, and he asked me, “Would you buy U.S. Treasury bonds?”

It is always uncomfortable to give personal investment advice without first understanding the other person’s timeline, family obligations, risk tolerance, etc.  A proper analysis takes time to conduct.  So, I hesitated to give him an answer in the few minutes available to chat.  Instead, I mentioned some important considerations regarding this question that may help him to develop his own answer.

The Doc was feeling a bit anxious about the recent economic, social and political news.  He believed the stock market was over-valued, and was looking for a “safe” investment for his hard earned money over the long run. Like many individual investors, the Doc found comfort in the U.S. Government’s ability to honor its’ financial obligations, so investing in U.S. Treasury bonds is considered a good safe haven when financial anxiety increases.

The safety is due to our country’s status as the world’s remaining super power, and the U.S. Dollar’s acceptance as the world’s reserve currency. The bonds are recognized globally as  “money good”, meaning that on the maturity date, investors expect to get paid back the full amount of their investment.

Although it is true that the probability of the government paying back Treasury bond obligations is very high, many individual investors are unaware of a real risk associated with investing in U.S Treasury bonds at this moment: interest rate risk due to “modified duration”.

Before we explain the risk of modified duration, let’s go over some fundamentals of all bonds.

Any institution that needs to borrow money, like the U.S. Treasury, State of Florida, Apple Corporation or the city of Detroit, can issue bonds. A $100 million bond issuance, for example, is simply a large loan, divided into 100,000 increments of $1,000. The issuing price is normally set at “par” or 100 cents on the dollar, with a $1,000 face value per bond.  The issuance comes with a fixed interest coupon payment to investors, and the bonds are freely tradeable securities that are regulated by the Securities & Exchange Commission.

Bonds are differentiated primarily by the credit quality of the issuer, measured by the ratings agencies.  Institutions like the U.S. Government are higher quality (lower risk) than smaller growing companies (higher risk).  The investor is compensated for investing in the higher risk bond by receiving a higher yield, or return, which comes in the form of a larger interest rate coupon.   Other variables include time outstanding, called maturity, and the underlying collateral, for example.

Most bonds are fixed-income securities, meaning that they provide a set coupon payment on an annual (or semi-annual) basis until the maturity of the bond, when the entire principal amount is repaid.

The fixed-income nature of these financial securities is the selling point to investors looking for consistency and stability of cash flows.  If you were a retiree living off of your nest egg, or an insurance company projecting out future claims, it makes sense to buy bonds assuming the issuer is able to make the payments on time.

Let’s say you invest in $10,000 worth of a U.S. Treasury bond that pays a fixed coupon of 2.25% annually, with a maturity date 30 years into the future. You would receive a $225 payment annually as income for 30 years, and then paid back on your $10,000 principal at maturity (30 years).

If you are struggling to earn a measly return in your bank account yielding close to 0%, and you don’t want to buy risky stocks, this may seem like an attractive alternative.  This may seem especially true, given the creditworthiness of the issuer, the U.S. Government.

An important concept is that the payments are locked-in when an investor buys a bond.  As long as the issuer remains solvent, you will get your $225 per year and your $10,000 back at maturity.

The problem is IF you want to sell the bond BEFORE maturity, for any reason, the value of the bond may not be $10,000.  Why?

Well, the U.S. Government continually borrows money in new bond issues, because of our need to cover the budget deficit.  Interest rates are dynamic, so the rates on a new (different) 30-year Treasury bond may be higher or lower.  Let’s say rates move up to 3% three years from now.  Would a new investor prefer to buy a new bond getting 3% annually, or buy your existing bond yielding 2.25%.  They would prefer the 3% bond.

So…what happens to the value of your three year old bond?  Well, bond prices and interest rate move inversely, so the price of your bond must fall to move the yield up to current market conditions of 3%.  Price up; yield down, and vice versa.

If you read the “Do You Rely On Digital Currency Too Much?”, I mentioned the unprecedented central bank monetary policies. The Federal Reserve Bank (the “FED”, our central bank) controls monetary policy, the supply of money, via manipulation of the Fed Funds Rate “FFR”.  The FFR is the interest rate that is used by banks and credit unions to lend money to each other overnight.

For decades, The FED has reduced FFR to stimulate economic growth whenever the feared a slowdown in the economy.

How does the lowering of the FFR, stimulate economic growth?

The FFR is the foundation from which most consumer rates like Prime, Mortgage, Student Loan, Auto, Credit Card, Savings Account rates, corporate and governmental borrowing rates, are determined. When the FED senses an impending economic slowdown and it wants to jump-start growth, it lowers the FFR.

This lowering action causes these correlated rates to decline and it becomes more attractive and affordable for consumers and institutions to borrow money for growth or consumption, which stimulates economic growth.

On the contrary, if the economy is overheating (1999 dot-com or 2006 housing bubbles), the FED may “tap the brakes” by increasing the FFR, resulting in higher consumer and lending rates, a disincentive to borrowing which slows down economic activity.

As you will recall, our 2006 housing bubble was created when borrowing money was too cheap and too easy.  The floor fell out from under the housing bubble due to an excessive amount of mortgage defaults, triggered by an inability for homebuyers to continue the excessive borrowing that fueled the “house-flipping”.  Consequently, the bad mortgage assets almost brought down the global financial system when the defaults accelerated in 2008.

At that point, the FED appropriately lowered rates and instituted a program of “Quantitative Easing”, a fancy name for creating new money out of thin air, and buying up financial assets to stabilize the system overwhelmed with panicked sellers. It worked.

Since the 2008 financial crisis, however, the FED has left the Fed Funds Rate at historically low levels in order to provide ongoing stimulus to the economy, but it has not been very effective with continued sluggish growth. Currently, it is at a very low rate of 0.5%, or 50 basis points.  The “FED” is very concerned, because they have left rates in an “emergency low mode” for over eight years.  Consequently, they are now threatening to raise the FFR back towards the normalized level of around 3%.

Why?

They are worried that by keeping the Fed Funds Rate so close to zero, there are limited tools for stimulating growth in the event of the next economic recession, which is overdue based on historical economic cycles.

The problem is that the players, from corporations to individuals to the U.S. Government itself, are now accustomed to very low borrowing rates, or cheap money.  Therefore, it is difficult to normalize rates to historical levels; similar to a substance abuser going cold turkey.  Nobody wants the party to end.

So what does this Fed Funds Rate dilemma have to do with discouraging an investment in U.S. Treasury bond?

The first point to understand is that the fixed-income nature of the bond also makes it vulnerable to a rising interest rate environment, which is inevitable after so many years of the Fed’s extraordinary low rate policy.   Fed Funds Rates are certain to increase significantly over the next 30 years, because it has very little room to go down!

This is where it gets a bit tricky, and provides the basis for my concern with this concept called “modified duration”.

Modified duration “MD” measures the change in the price of a bond in response to a change of 1% in interest rates.  MD is higher for longer maturity and low coupon bonds, like the U.S. Treasury 30 year bond which has a very high Modified duration of about 22.  This means that if interest rates move up just 1%, your bond falls 22% in value, or from $10,000 to $7,800.

Here are a few additional bonds and an estimate of how their modified duration would affect the price in the FED’s latest “dot-plot” estimate of 3% Federal Funds Rate in 2019.  Notice how the “safest bonds” with the low coupons and long maturity are most sensitive to the interest rate risk.  The worst rated, casino/lodging operator Boyd Gaming, is the least sensitive to rising interest rates.

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Finally, individual investors are not able to “hedge” or mitigate their risk with sophisticated financial derivative instruments utilized by the professional money managers.

Therefore, the apparent safe investment into 30-year U.S. Treasury bonds is a lot more precarious than most realize.

There will be a lot of unrealized losses (realized if you must sell) to owning bonds when the FED inevitably moves off of their unprecedented low rate policy.

And this is why, as an individual investor, I would avoid buying bonds….

 

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