Should You Be Worrying About Bonds?

Today, Standard & Poor's (the bond rating agency) cut the debt of Japan to AA-, it's fourth highest rating.  I remember back in 2003, a client asking me about his Maryland municipal bonds that were AAA-rated, paying excellent coupons and performing well.  He asked why we didn't go out and load up on more.  I cited Japan's last rate cut in 2002 and stated bluntly, "If they can cut Japan's rating, they could Maryland's too."

Worries over bond downgrades will remain a major story for the remainder of 2011. 
Almost unheard of in the history of the US bond market are discussions of US sovereign debt being downgraded and the near panic that would ensue.  This past fall the city of Harrisburg, PA missed a bond payment prompting default procedures and a sudden chill in the almost $4 trillion municipal bond market.  An article this past week in the Wall St. Journal discussed the letter a MD resident received regarding her MD Health and Higher Education bonds and the letter offering 50 cents on the dollar if she sold (she did).  If more stories of defaults surface and people panic, the trading markets for more than a few bonds could all but disappear overnight. 

Question: So, I don't want to panic but do want to take steps to protect myself, what do I do?

• The first thing you need to do is have an adviser pull some research on the bond.  Trading history, size of the offering, the prospectus if available and most recent disclosure document would tell a lot.  An examination of the quality of the bond vs. similar competitors should be done to truly evaluate how it would hold up in a panic. 
• Second, an examination of any change in your risk profile should be discussed and noted by your adviser.
• Third, the bond needs to be examined in relation to other bonds in your portfolio; and another time against the client's overall allocation.

Bonds are confusing; I just don't understand them and wonder if I should be in them at all. 

• Bonds are a lot more difficult for the average investor to understand.  Data is readily available regarding any stock or mutual fund in existence.  To research a particular bond requires knowing where to look plus perspective on the specific market your bond exists plus the bond market as a whole. 
• Unlike stocks which trade on exchanges like NASDAQ, AMEX, and the New York Stock Exchange, there is no organized exchange where bonds trade. 
• Bonds are priced on the spread (the difference between the bid and ask price).  The majority of the time, individual buyers buy and sell completely blind to the spread the broker receives for trading the bond.  Because of this, retail bond investors often get taken advantage of.
• Knowing which bonds are safe, in today's market, is really left to professionals who are experienced in the bond market.  There is a vast array of bonds with myriad characteristics that the average investor is not equipped to understand.   
• Your best defense is working with an adviser you trust.

At Mid-Recovery: What Does Our Economy Look Like?

2010 proved to be a continuation of the recovery that began in 2009.  For the year, the Dow Jones Industrial Average finished up 11% with the S&P 500 up 12.8%, and NASDAQ up 16.9%.  Concerns over rapidly rising interest rates proved false with rates actually dropping.  When rates fall, bonds do well as just about every category of bonds had positive returns.  The second year of equity gains can be attributed to five consecutive quarters of strong corporate profits.  Businesses continued the trend of reducing costs, holding steady on payroll and holding greater than normal cash.  Strong corporate performance and business spending remains the best hope for a stubbornly high 9.4% unemployment rate.

Now that talk of a double-dip recession has faded, what will the next few quarters look like? 

The Republican-controlled Congress will attempt to bring more fiscal discipline to new legislation and the budget ceiling.  Concerns over both Federal and state budget deficits will grab headlines causing investors and businesses alike to remain more cautious than normal.  Investors caught a temporary break with the extension of many tax cuts from 2010 but new health care mandates will draw employers' attention to spiraling costs.  While 2010 was a speculator's market in commodities and foreign currencies, look for a reversal particularly in gold and silver.  We expect commodities pricing to revert back to the rules of supply and demand with China and other emerging economies increasing their demand for such raw materials.  Money will continue to flow to the higher interest-rates in foreign currencies until either inflation or a stronger US economy draws money back to less speculative investments.
Result: Take diversified approach to both US and foreign equities; clear winner is undetermined.

We will probably will not see higher inflation, municipal bond defaults nor higher interest rates in 2011.  The Fed is scheduled to buy $600 billion of additional Treasuries this Spring to help keep rates low.  With companies still below capacity, businesses will unlikely raise prices for either products or wages. Due to the new makeup of Congress, government spending and investment will add less to overall growth.

Still hampering the economy are record high personal bankruptcies and commercial real estate delinquencies.  Look for only gradual improvement in 2011.

What are some of the wild-cards in 2011? 

• Federal Stimulus: Quantitative easing (or, the Government pumping an additional $600 billion into the markets) favors investors who buy riskier assets such as high-yield bonds, commodities and foreign securities.  The Fed feels this stimulus is necessary to ensure stability in the markets.  A change in tenor by the Fed could prove destabilizing. 

• New Jobs: 2010 non-farm job growth was 1 million new jobs.  The problem is that we had seven million more jobs at the market peak in December 2007.  There is a direct correlation to the number of new 2011 jobs and overall growth in the economy. Will the new long-term unemployment rate be 6% instead of 5%?  What are the social and economic implications of such a change?
• China:  Increasingly, US policies are determined by events in Asia with China at the center.  What impact will China's military buildup (and political response) have when confronted with an untested, new leadership in an increasingly unstable, nuclear North Korea?  China's double-digit growth rates and larger world role will continue to draw Wall Street firms and institutional investors. Closer ties to the West will bring new pressures on a China that may be unable or unwilling to meet the traditional responsibilities of a world power.  China's thirst for resources and the constant inflationary pressures on food, housing and fuel will challenge Chinese leadership in dealing with an increasingly demanding  Chinese work force.