Sovereign subprime

In my opinion, the next default wave (other than commercial real estate, Alt-A residential, and option adjustable rate mortgage residential) will be public instead of private debt.

Greece is working hard to illustrate why I’m worried about this, as is Argentina, the Baltic states, Spain, Italy, Portugal…you get the picture.

But, it’s not just smaller countries that are getting into the subprime spirit, it also includes (currently) prime credits like Japan, the United Kingdom, and (shock, horror!) the United States.

And, it’s not just countries, it includes other public debtors like California, New York, Dubai World, Fannie Mae, etc.

How did this mess get so bad? The same way subprime borrowers and lenders got into trouble. Namely, public bodies are spending more than they are taking in, and lenders are doing a lousy job making sure borrowers can repay. This is not rocket science.

Whether it’s California, the U.K., or Greece, the problem is incurring too many obligations while not taking in enough revenue to pay.

Japan is unique in that it’s as much of a demographic time bomb as anything else. Their real estate, stock market and banks collapsed 20 years ago, but they decided not to face the music. Added to this, their population isn’t having enough kids to replace the elderly, and they won’t allow enough immigration to make up for that deficit. Finally, a big dash of inflexible labor markets and decreasing savings rates and you get a country most likely unable to pay its debts.

How do countries go into default? If they are small, they tend to get bailed out by bigger countries or the International Monetary Fund. Big countries, on the other hand, tend to inflate their way out of debt. The trouble there is that when lenders (bond buyers) realize inflation is the solution, interest rates take off. Not a pretty picture.

The financial crisis of the last two years has made this problem dramatically worse. Instead of letting bad borrowers and lenders face the music, governments of the world have bailed out uneconomic borrowers and uncritical lenders. We haven’t eliminated the debt problem, we simply shifted it from private to public. But, the scale is so large, as are the promises governments have made to pay future benefits, that the end-game is much sooner than anyone thought.

When will these defaults come about? Probably not for several years in the case of prime credits, but much sooner for smaller sovereigns. This is likely to stir credit markets and cause a lot of volatility in commodities and stocks.

It used to be you could count on countries, or at least the right countries, to pay their debts. But now, it costs less money to insure against the default of IBM than it does the U.K. May you live in interesting times, indeed.

This is a good time to be very selective of investments (especially debt), to be prepared for very volatile markets, and to expect higher interest rates and inflation. It may take some time to arrive, but when it does, you won’t want to own low interest debt or highly indebted companies.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

The peril of bonds

Long term bonds have beaten stocks for decades.

As reported by Rob Arnott (chairman of Research Affiliates), 20 year bonds have provided better returns than the S&P 500 starting any time from the 1979 through 2008.

That’s a startling fact to many investors who’ve been told, ad nauseam, that stocks always do better than bonds over the long run.

This out-performance by bonds has not gone unnoticed by investors, who are selling stock mutual funds and buying bond funds.

Is it time to abandon stocks and buy bonds?


You shouldn’t drive your car by looking in the rear view mirror, and you shouldn’t invest your money that way, either. The past can be a wonderful guide to the future, if and only if situations are sufficiently similar.

But, the situation over the next 30 years is highly unlikely to be the same as it was over the last 30 years.

For starters, inflation was in double digits 30 years ago. When inflation is high, bonds sell at super-cheap prices. When high inflation is tackled, as it was by Paul Volcker in the 1980’s, and continues to decline for another 20 years, as it did, then bonds have remarkable performance.

That is not the situation today. In fact, reported inflation is at an all time low, showing its first annual decline since the mid 1950’s. Bond yields reflect this low inflation with record low yields.

Bonds will not perform as they did over the last 30 years because inflation isn’t starting high and going to record lows. Count on it.

In addition, the threat of growing inflation is as high now as it was the last time bond rates were this low, in the 1960’s.

At that point in time, government spending was going through the roof to fund new social programs like Medicare and to fight an on-going war in Vietnam. If that sounds familiar to you, it should.

The U.S. government is running record high deficits as a percentage of the economy in an attempt to jump start an economic recovery, fight on-going wars in Iraq and Afghanistan, fund social programs like universal health care, and reduce carbon emissions to prevent global warming. If you think that won’t sooner or later lead to high inflation, I’ve got a few bridges I’d like to sell you.

Just because long bonds have done well in the past doesn’t mean they will do well in the future. If deflation continues for some time, as many smart people think it will, long bonds will do well. But, I believe that situation will only be temporary.

When inflation kicks up, as I think it will, long bonds will be gutted.

Stocks may not do well in the short run, but they offer excellent long term protection against inflation. Stocks are also selling at historically low prices relative to bonds. Bonds are now priced for perfection (low or declining inflation) whereas stocks are priced for a sustained recession.

Stocks may under-perform bonds over the short run, but over the long run, I don’t think its even a contest–stocks will almost certainly out-perform over the long run.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Bonds aren’t as safe as they may seem

When stock markets tank, most people think, “boy do I wish I owned bonds.”

Let me make this clear–bonds are NOT riskless. Although people perceive them as riskless, they are not! Bonds face risks from default and inflation.

Many people wish they owned bonds because U.S. Treasury bonds have done so well over the last year and a half. That doesn’t mean all bonds have done well. Junk bonds, corporate bonds, investment grade corporate bonds, municipal bonds, mortgage backed bonds, etc. have all been decimated.

To have done well with bonds during this downturn, you’d have needed to be prescient enough to know exactly which bonds to buy and no others. Very few people are that good at forecasting beforehand. Everyone is afterward–but those are profits you can’t eat.

So, what are the risks for bonds. The first risk is the same as for stocks–what you buy can become worthless. Government bonds rarely default, but rarely is not never. The second risk is inflation. Government bonds are very vulnerable to inflation risk (the exception being inflation protected bonds, but even they face inflation risk if the consumer price index differs from your cost of living increases).

How can a bond become worthless? A bond has a senior claim on a business’s assets. That means bondholders get paid before equity holders. But, that claim comes after customers and after the tax man. If a company goes bankrupt, bond holders can still be wiped out. They get paid before equity holders based on what’s left, but that doesn’t mean they will get paid back in full, and it doesn’t mean they will get paid back with certainty.

The bigger threat to bondholders is inflation. And, here, I believe stockholders are actually better off than bondholders.

Suppose you buy a 3% bond and inflation goes up. If you own a short term bond, your impact is smaller than if you own a long term bond. A short term bond can be rolled over into a higher yields as inflation goes up. A long term bond doesn’t have this luxury.

How much of an impact am I talking about? Pretty big. Suppose inflation goes up by 3% more than the market expects: the value of a 10 year bond would decline by around 20% (all things equal). A 30 year bond would decline by almost 40%! If inflation went up 6% more than people expected, then a 10 year bond would decline by 40% and a 30 year bond would decline by over 60%! If you believe bonds can’t go down like stocks, think again!

The price declines I referred to above would happen quickly, but you’d still get back your full principal at maturity, right? The problem is that those dollars will be worth a lot less than they are now. Whether you sold right away or held to maturity, higher than expected inflation will hammer long term bond holders.

That’s true for government bonds as much as any other bond. In fact, I believe government bonds are much more risky than usual now. Almost every other type of bond is trading at record high relative yields, so they are safer from inflation risk than government bonds that are at record low yields. Government bonds are extremely unlikely to default, but the dollars you’d receive may not be worth much.

Most people seem to under-estimate the risks of bonds. Default risk and inflation risk make them risky, whether people recognize it or not. Talk to anyone who owned bonds in the 1970’s, and they’ll tell you what owning bonds felt like in an inflationary and recessionary environment.

Stocks may have a lower priority claim on a business’s assets, but they do adapt to inflation better. The revenues and costs of most businesses tend to keep up with inflation over time and so do their earnings. This protects them, over the long run, from the ravages of inflation. Stocks may not do well when inflation increases, but they do very well when inflation levels off or decreases. In the long run, they protect shareholders from inflation better than bonds.

Is unexpected inflation likely? Perhaps not in the short term, but over the next 3 to 5 years, I believe high inflation is very likely, and perhaps more than the 3% or 6% I referred to above.

Stocks aren’t riskless, but neither are bonds. Stocks face more risk from default, but less risk from inflation. When government spending is expanding like never before and the Federal Reserve is printing money at a rapid pace, it’s a good time to consider inflation protection and the fact that stocks may turn out to be less risky than bonds over the long run.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.