Downside Risk for Bond Investor


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Will inflation result in lower overall bind returns for 2012. Or has it already happened?

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Downside Risk for Bond Investor

  1. 1. Gnostam  LLC     March  13th,  2011   PO  Box  960     Inverness,  CA  94937   Newsletter     Independent Investment Advisor DANGERS FROM THE US BOND 1941 when the US started its massive MARKET: WWII spending. Bill Gross the largest Bond Fund Manager In nominal terms the average interest rate in the world announced this week that for US government bonds for the period Pimco, manager of the Bond total return from 1790 to date is around 6%. Today fund had sold his entire holding of US we have rate around 3.40% for the 10 year Government Bonds. and Fed Funds at 0.25%. This is clearly an unsustainably low rate of interest and This is big news. clearly this is Bill Gross’ motivation for the sale of his massive position in US As can be seen from Figure 1 below, the government debt. rate of increase pf US Debt as a % of GDP is on the sharpest increase since [Continued on Page 3] Although the US Figure  1.    US  Government  Debt  as  %  GDP  1792  to  2010.    Source:  US  office  of   management  and  budget.       1  
  2. 2. Gnostam  LLC     March  13th,  2011   PO  Box  960     Inverness,  CA  94937   Newsletter   Gnostam LLC performance Graphs Chart  1  Gnostam  Performance   Gnostam  was  established  in  February  2004.   Since  inception  the  annualized  rate  for  return  for  a  client  portfolio  managed  by  Gnostam   LLC  has  returned  a  total  9.56%.   For  the  period  from  January  2007  to  date,  the  managed  portfolio  has  returned  an  average  of   1.53%  vs.  -­‐2.55%  of  the  S&P  500.    Please  see  table  below.       2  
  3. 3. Gnostam  LLC     March  13th,  2011   PO  Box  960     Inverness,  CA  94937   Newsletter   Government inflation statistics show that every item that has gone up in price, such as inflation is tame, the exclude almost energy, all foods, such as wheat and corn Chart  2.    US  Interest  rates  cycles   Fig  3.    US  Inflation  rate    Jan  1990-­‐Jan  2011     3  
  4. 4. Gnostam  LLC     March  13th,  2011   PO  Box  960     Inverness,  CA  94937   Newsletter   Portfolio  Changes  and  Recommendations  for     February  15th  2011   2011 will be a difficult year for investors. Too The following is a table of our best much money has come into the market, buys: especially money that chases returns, such as mutual find money. There is almost no chance • Photronics [PLAB] 12.2 x in my mind that the market will go much higher multiple; than it is at the moment. I would sell most • Kulike & Soffa [KLIC] 11.9 stocks that are financial and related to housing, multiple; and retail. Instead, buy rare metal miners, gas • Cambrex [CBM] 8.9 multiple; pipelines and gas producers. Once the value of solar stocks has come down, they may be a In Oil and Gas exploration, valuations place to look. of the deep-sea drillers [<4,000 feet] are attractive. With the new Petrobras Gas pipeline strong buys are as follows: find, there has been a re-deployment from the GoM to the deep offshore Kinder Morgan, [KMI] drilling areas off the coast of Brazil, El Paso, [EP] and rates are expected to climb by Williams Partners, [WPZ] 11% in 2011. Best choices are: Plains All America, [PAA] • Helix Energy, [HLX] 12.7 x Most of these will be subject to consolidation in multiple; my view. I would add the following utility, UGI, • Diamond Offshore [DO] 11.33 x which is a liquefied natural gas play. multiple; In genomic equipment and services, Life Solar Plays that may be of interest: technologies, [LIFE] while expensive has an almost unique exposure to the high quality LDK SOLAR, [LDK] $14.45 earnings from genomic research and genomic MEMC [WFR] is a buy tools. If I were a Pfizer, this is the type of company I would want to acquire. FSLR is a short. Semiconductor Equipment has great potential for producing superior returns in the first quarter of 2011.   4  
  5. 5. Gnostam  LLC     March  13th,  2011   PO  Box  960     Inverness,  CA  94937   Newsletter   have been rising consistently and are one been grumbling for years about the failure of the reasons for the revolts in the Arab of the US Government to provide for a world. stable currency. Most bond investors who have bought US Treasuries from abroad The real shock to bond investors will come have been loosing their shirts in a total when they realize that there are fewer and return basis, if their base currency is the fewer buyers of US Government bonds. Euro or say the Ozzie $. In fact the only The Japanese will probably have to sell real buyer of Treasuries in size is the US some positions following the terrible Government and the Fed. Tsunami/Earthquake. The Chinese have   5  
  6. 6. Gnostam  LLC     March  13th,  2011   PO  Box  960     Inverness,  CA  94937   Newsletter   WHY A RISING BOND YIELD MATTERS. priced. Consider this scenario. The US Treasury This game cannot continue for ever. and the Fed buy entire portfolio’s of junk Something has to give, Either: or underwater assets of banks in 2008- 2009. This is because the banks are 1. Short term rates will rise unable to finance these portfolio’s in short regardless of the Fed, or bond term money market’s as the money investors will no longer accept a market does not believe banks are 3.4% return for holding long term, solvent. Not to mention the impact on the debt, given that the US $ has cost to service US Government debt at devalued 3% in one year relative higher rates. to the Euro; 2. Or inflation will accelerate and For over 2 years large US banks [Bof A, destroy the value of US Citibank et al] have been recapitalized by government debt. a massive subsidy from the US taxpayer. The banks can borrow at 0.25% and re- It seems that Bill Gross is not waiting invest in Treasuries at 3.5%. As there are around for option 2. only 2 ways to make money in bonds, [interest rate risk or credit risk] the US What happens if 5-30 year rates as it government is subsidizing the banks seems will rise to a “normal” 4.5%-7% “interest rate risk”. There is no interest range? rate risk for the banks as long as Ben Bernanke artificially guarantees access to 1. The banks will be in terrible 0.25% Fed Funds rates, a 3.25% shape. The value of their “long” unleveraged spread, which once dated financial assets will leveraged the customary 10-20 times is a implode by 20-25%. The cost of >32.5%. No wonder banks are making funding these positions will rise, money. And they are paying senior bank making it necessary to sell bonds employees great bonuses, while banks into a down market; shareholders have lost 1.5% on aggregate 2. The banks will be too big to fail over 5 years. In essence the banks have yet again, and the Fed will have survived with the value destroying to bail them out again; capabilities intact. 3. Our Asian investors will finally throw in the towel on US All this time banks have not lent. They Government debt; have loaded up their balance sheet with 4. All debt will loose value; US Government debt and earned from the 5. Bond funds will begin to unwind; spread between short term an long term 6. Pressure will be put on money Government debt rates. The banks in market funds again as funds flow essence have privatized their losses, [we into these as only safe haven, the taxpayers own those] at the very time only to flow out just as fast once when we should be spending our way out the opportunity cost of holding of the recession. That and absurdly high 0% balances is taken account of. entitlement spending make holding US Government debt unattractive. So I would urge you to do what Bill Remember US Government debt is the Gross has already done. benchmark upon which all other debt is   6  
  7. 7. Gnostam  LLC     March  13th,  2011   PO  Box  960     Inverness,  CA  94937   Newsletter   Sell your bonds. It may be your last chance nonfinancial assets—all the to do so without losing your shirt. commodities that are in big demand to keep these economies humming. Resist the urge to buy Muni Bond funds. China, in particular, has been buying They will underperform, and you will lose up hard assets worldwide, often money on them as they face redemptions instead of dollar-denominated and are forced to sell into the worst Muni investments. market in 50 years. What to do if you are a Euro Investor? The $ has taken a real beating. And the Treasury never speaks of the need for a strong currency any longer.     The supply of dollars is conspicuously on the rise. With interest rates at close to zero in the U.S. since the financial crisis of 2008, and the Federal Reserve Board no longer able to lift the economy As long as monetary policies remain by lowering interest rates, the government linked to the U.S., inflation pressures has turned to "printing money," boosting will only intensify in emerging the money supply through quantitative markets. Emerging countries will be easings. The most recent, involving left with no choice but to adopt purchases of up to $600 billion of independent monetary policies and Treasury bonds, is expected to run revalue their currencies, or risk social through June. chaos. Such a move is politically sensitive; although it will increase the Given the concern that Treasury rates purchasing power of their now have almost nowhere to go but up, constituents, it will cut into business which would reduce the value of bonds, exports. Likewise, if a decoupling of money has been flowing to those exchange rates comes to pass, U.S. economies with higher growth rates than consumers can expect to see the the U.S., such as China and Brazil, but value of their money depreciate, and whose interest rates are comparatively U.S. companies can expect exports low because they are linked to those of to rise. the U.S. Thats led to a boom in borrowing and spending, and investing in   7  
  8. 8. Gnostam  LLC     March  13th,  2011   PO  Box  960     Inverness,  CA  94937   Newsletter   A similar scenario is being played out in currency will end in the next 10 years. Europe, where Germanys economy has The greenback, he says, is likely to share been vibrant and inflation is a threat, while the throne with the renminbi and the Spain, in particular, as well as Ireland and euro. He sees the dollar eventually Portugal and Greece are mired in debt and dropping 20% in order to make U.S. depressed economies—yet all are tied to goods more appealing for export. the same currency and interest-rate policies. Barrons Randall W. Forsyth began predicting the end of the dollars SWISS FRANC AS A SAFE HAVEN: hegemony in December. This has clearly been the winning currency Reflecting the growing pessimism, short in terms of safe haven. As can be seen positions in the dollar, or bets against it, from the chart below, this is the place to on the International Monetary Market hold your cash if you want it to hold its currency-futures exchange reached the value. highest level ever during the first week of March, reaching some $41.5 billion and $ TO LOOSE RESERVE STATUS? exceeding the previous record of $38 billion in November 2007, according to Barry Eichengreen, a professor of Nomura Securities. The short position is economics and political science at broad-based, but it appears to be biggest University of California at Berkeley, against the Canadian dollar, the penned an opinion piece in The Wall Australian dollar, the Swiss franc and the Street Journal predicting that the Japanese yen. dollars reign as the dominant world   8  
  9. 9. Gnostam  LLC     March  13th,  2011   PO  Box  960     Inverness,  CA  94937   Newsletter   Its getting easier for individuals to take Van Eck Globals MarketVectors have all their own dollar positions. It can be as entered the fray, with nearly 40 funds simple as buying stock in big multinational now available to investors to pursue companies found in the Standard & Poors strategies as simple as hedging a 500; they derive ever-increasing portions portfolio or as sophisticated as predicting of their profits from overseas sources, a currencys direction, based on technical which gives them a natural hedge. Coca- analysis. Cola (ticker: KO), IBM (IBM) and ExxonMobil (XOM) are prime examples. Pimcos Gross recommends ETFs tied to currencies of faster-growing emerging Alternatively, any number of online markets, such as China and other Asian brokerage firms, including TD Ameritrades countries, plus Brazil and even Canada thinkorswim platform, make sophisticated and Mexico. software tools and automated trading available. Foreign-exchange specialists WisdomTree Dreyfus Emerging FXCM (FXCM) and Gain Capital (GCAP) Currency Fund (CEW), at nearly $400 each came public within the past few million in assets, is a popular, actively months, taking advantage of the managed offering that invests in eight to heightened interest in currency trading. 12 emerging-markets currencies in equal Another, Utah-based Interbank FX, says it proportions, using derivatives such as is watching its competitors experiences swaps. The fund is invested currently in closely and considering its own initial Mexico, Brazil, Chile, Poland, Israel, public offering. Turkey, South Africa, China, India, South Korea, Taiwan and Malaysia. It had a 6% Certificates of deposit in euros and other total return for the past 12 months. nondollar-denominated world currencies are also available. EverBank, a BY FAR, THE BIGGEST OF THE Jacksonville, Fla., consumer bank, offers currency ETFs is the PowerShares DB such a service through its Brentwood, Mo.- U.S. Dollar Index Bullish (UUP), with based world-markets division. $873 million in assets. Theres also a bearish version of that fund, but this isnt One of the most effective approaches is to necessarily the way to hedge against a pick a good exchange-traded fund, the falling dollar. An advantage of ETFs is same strategy many investors are that they can be shorted, and research following for gold. ETFs based on conducted by Ned Davis Research currencies and currency strategies have suggests that long-term investors could flooded the market, especially in the past do as well, if not better, by shorting the few years, as demand has heated up. The bullish fund than by investing in the assets of the these funds now total $6.3 bearish fund, owing to complications billion, approaching the level of the red-hot related to daily rebalancing and energy ETFs. compounding. Rydex SGI launched the first currency There are also less popular exchange- exchange-traded fund in 2005, the traded notes linked to currencies. ETNs CurrencyShares Euro Trust, which is are more like bonds, in that they pay no essentially a euro-denominated money- interest but carry a guarantee that the market fund. Since then, Barclays iPath, issuer will make a cash payment at Invesco Powershares, WisdomTree and maturity equal to the return of an   9  
  10. 10. Gnostam  LLC     March  13th,  2011   PO  Box  960     Inverness,  CA  94937   Newsletter   underlying index. However, exchange- No ones recommending that the traded notes carry credit risk; they are average investor start actively trading in treated as unsecured debt of the firm that foreign exchange, but to maintain a issues them. competitive rate of return on investments, and to assure a standard of living that is competitive with the rest of the world, U.S. investors must become better acquainted with the relative values of global currencies as a matter of course—and not just when planning vacations abroad. A truly diversified portfolio will now also need to hold some currencies. Some of Americas more savvy corporate titans have gotten a jump on the coming shifts in the structure of the currency market. In the past six months, and for the first time, Caterpillar (CAT) and McDonalds (MCD) have received approval from the Chinese government to issue bonds in Hong Kong based on the Chinese renminbi— so-called "dim sum" bonds— to finance their business projects in China. The moves save the companies the expense of converting bonds issued in dollars into renminbi. CHINA, NOW THE WORLDS second-largest economy behind the U.S., went even further in mid- January when its 70%- government-controlled Bank of China began allowing individual and corporate accounts to buy and sell renminbi at its New York and Los Angeles branches.   10  
  11. 11. Gnostam  LLC     March  13th,  2011   PO  Box  960     Inverness,  CA  94937   Newsletter   Individuals are limited to trading the volume is already eight times as large as that of equivalent of $4,000 renminbi a day the worlds stock markets. All those folks who and $20,000 a year, but its another spent much of the past decade buying step toward putting the renminbi in a emerging-market stocks might now do well to league with the dollar, yen and euro. consider those countries currencies. The foreign-exchange market is far too big for investors to ignore, and its only getting bigger. By some estimates, its tradingDisclaimer:The information and any statistical data contained herein have been obtained from sources which webelieve to be reliable, but we do not represent that they are accurate or complete, and they should not berelied upon as such. All opinions expressed and data provided herein are subject to change without notice.Gnostam LLC and/or its shareholders, directors, officers and/or employees, may have long or shortpositions or deal as principal in the securities discussed herein, related securities or in options, futures orother derivative instruments based thereon. The securities mentioned in this report may not be suitable forall types of investors. ALL investments involve different degrees of risk. You should be aware of your risktolerance level and financial situations at all times. Furthermore, you should read all transactionconfirmations, monthly, and year-end statements. Read any and all prospectuses carefully before makingany investment decisions. You are free at all times to accept or reject all investment recommendationsmade by the Gnostam LLC. As you know, a recommendation, which you are free to accept or reject, is nota guarantee for the successful performance of an investment and we are expressly prohibited fromguaranteeing accounts against losses arising from market conditions.Past performance is no guarantee of future results, and current performance may be lower or higher thanthe performance data quoted.Investment Disclaimer All investments involve different degrees of risk. You should be aware of yourrisk tolerance level and financial situations at all times. Furthermore, you should read all transactionconfirmations, monthly, and year-end statements. Read any and all prospectuses carefully before makingany investment decisions. You are free at all times to accept or reject all investment recommendationsmade. All products sold are subject to market risk and may result in the entire loss to the clientsinvestment. (For example: excessive withdrawals may result in the depletion of your account). Pleaseunderstand that any losses are attributed to market forces beyond the control or prediction of GnostamLLC. As you know, a recommendation, which you are free to accept or reject, is not a guarantee for thesuccessful performance of an investment and we are expressly prohibited from guaranteeing accounts Gnostam  LLC   5731  Kirkwood  Place  N   Seattle,  WA  98103  USA     E-­‐mail:       11