Bond Market Gyrations – July 2004

July 19, 2004
Dow Jones Average: 10,140
S&P 500: 1,101


 

Bond Market Gyrations

 

There is significantly more money invested in bonds in the U.S. than in stocks. Whereas stocks move independently of each other, the market price of bonds changes every day in unison so that all bonds, regardless of when they were issued, reflect the current interest rate level. Many investors buy and hold bonds until the principal is repaid on the maturity date of the bond. Other investors may want to sell their bonds before maturity to raise cash for other purchases or for personal needs. The bond market exists so that investors can get in or out of previously issued bonds at a fair price that reflects ongoing changes in interest rates.

The past few years have been the perfect environment for bond investors. In a time of economic uncertainty bond investors have enjoyed steady interest payments, a rising value for their bonds, lower tax rates on the interest, and a subdued inflation environment. It is no wonder that many investors fell in love with bonds. The love affair continued until April 2004 when it became apparent that the Federal Reserve was going to start increasing current interest rates after years of lowering rates. The price of existing bonds tumbled on that realization even though the Fed waited for several months before raising rates one quarter point in June.

Many investors became alarmed by the rapid downturn in bond values reflected on their April statements. We feel that bond investors should focus on the real after-tax, after-inflation return produced by their bonds and largely ignore monthly gyrations in bond prices. The monthly swings in bond values do not mean much unless one intends to trade in and out of bonds on a frequent basis, or unless one is forced to liquidate some bonds at a low price. If an investor holds a bond until maturity all the fluctuations up or down in the market price will mean absolutely nothing. The bond will mature at face value (the amount originally borrowed by the issuing entity) regardless of any subsequent changes in market price. Whereas stocks can change dramatically and permanently in price, bonds all return to face value as they mature. Bonds issued by reliable entities such as the U.S. Government or highly rated states and municipalities are intrinsically dull instruments designed to give the investor a modest, steady return with safety of principal. Investors should not become too excited by a temporary rise or fall in the value of such investments.

The real return for investors who hold a bond to maturity is the rate of interest they receive minus taxes and inflation. While tax rates can be estimated with some precision, the inflation rate remains the great unknown variable. A high rate of inflation can badly erode the purchasing power of the capital one receives when a bond pays off at maturity. U.S. Treasury Inflation Protected Securities (TIPS) are guaranteed to match inflation and pay annual interest as well. This type of bond has grown in popularity, because it allows investors to calculate in advance their real after-tax, after-inflation return. Municipal bonds have the advantage of being tax-free which can lead to the best overall return in a stable or subdued inflation environment. In either case, TIPS or municipals, more secure bonds are not designed to give investors much more than a two percent real rate of return after inflation and taxes. It has been that way for the past hundred years and is likely to continue. Investors attempting to make a higher return on bonds have to risk capital on bonds issued by companies or foreign governments that may default

Current Strategy

The U.S. stock market and bond market have both trended slightly down throughout 2004. It is difficult to do much with markets that are relatively high and rather directionless. On the stock side we have ventured outside the U.S. looking for more attractive values. While one can find higher growth rates and lower stock prices overseas there are currency and political situations that must be considered. We feel comfortable with the selections we have made so far in Mexico, South Korea, and Japan. On the domestic side, stocks are giving back part of the gains they made in 2003, as prices went higher than justified by business conditions. There has been pronounced weakness again in the technology stocks with a number of big name companies, such as Oracle and Nokia, heading down to their 2002 low points. We made a recent buy in the semiconductor sector and are considering other technology stocks. If the broad erosion we are seeing in stock prices turns into a more substantial decline we will be able to accelerate the pace of new acquisitions..

The bond positions we purchased for clients in July 2003 have done well in light of the bond market decline. The inflation protected securities are about the only type of bond holding up this year as investors attempt to keep pace with a higher inflation environment. The shorter term treasury securities held by our clients did fall in value in the second quarter of 2004, but are steadily recovering as they come closer to maturity. Investor attitude toward bonds is becoming more favorable again as weak economic numbers in June undermine the case for higher inflation and higher interest rates.

There are many variables that could affect the investment markets over the next twelve months. The election, deficits, elevated real estate prices, and oil supply are some of the factors that may influence predictions for stocks and bonds. We think that this is a time to maintain modest exposure to selected stocks and bonds, while remaining flexible and prepared for a bigger shift in prices.

Return to Archive