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.
