One simple, safe investment is benefiting as a severe economic crisis spreads from Asia to Wall Street. It’s the good old U.S. Treasury bond.
If you own a bond, its value rises as interest rates fall. And rate have been falling sharply. The yield on the bond with the longest maturity, 30 years, stood at 5.92 percent Friday.
This decline is “not a fluke,” says Brian Wesbury, chief economist for a Chicago research firm. He reminded clients that “in January 1966, with inflation near current levels, the 10-year Treasury yielded 4.6 percent.” It’s now 5.8 percent.
Thanks to falling rates, bonds have lately been outstripping stocks. For example, since June 12, the Dreyfus 100% U.S. Treasury Long Fund has returned 10.2 percent - in interest payments plus the increase in the value of the bonds it holds. But the Dreyfus Growth and Income Fund, which owns stocks, has returned only 2.9 percent.
Does all this mean you should sell your stocks and jump onto the Treasury bandwagon? Not at all. It does, however, mean that this is an excellent time to make sure you own enough bonds as part of your overall asset-allocation strategy.
How much is enough? If you’re in your twenties or thirties and saving for retirement, the right level of bonds is usually none. With time on your side, history shows that you can ride out severe declines in the market and, over time, earn average annual returns of 10 percent with stocks.
But, as you get older, you need to balance your equity holdings with bonds. They dampen the overall volatility of your portfolio, so that, while returns are lower, so are risks. As you approach retirement, you don’t want to see your nest egg decline by 20 percent in a single horrendous stock-market year.
Experts say that at age 40, a good mix is about 80 percent stocks and 20 percent bonds. At 50, you should be shifting to about 70-30. These are just guidelines; personal tolerance for risk is another big factor. If sharp moves in stocks churn your stomach or interrupt your sleep, then you should own more bonds.
Besides ballast, bonds have two other uses: They pay current income in the form of interest (though it’s taxable at the highest rate, so it’s smart to hold them in a tax-deferred account), and they can be used for speculation - that is, trying to make short-term profits on the increase in their value as rates fall.
Speculation is not much different from casino gambling. It can be lucrative and thrilling, and you also can lose a lot of money. But one attraction of Treasury bonds over roulette is that, if you hold till maturity, you know that, in the worst case, you’ll get your investment back in full.
That’s what makes the crisis in Asia so enticing. Consider zero-coupon bonds. These are Treasuries that have been “stripped.” They don’t pay interest. Instead, investors buy them through brokers at a discount to their full face value - and get that value at maturity.
For example, by paying about $4,600 today, you can buy a zero that will give you a guaranteed $10,000 in the year 2011. That’s an effective interest rate of 6 percent, or a little higher than a standard bond that matures in 14 years. If rates fall, your zero will jump in price. You could sell it then at a nice profit; the market for zeroes is always liquid.
Of course, if rates rise, the value of your zero will fall. But, then, you can take the second alternative and merely hold it to maturity. It’s a nice feeling to know that, in the worst case, you’ll more than double your money in 14 years.
While guessing the course of interest rates is normally as fruitless (and expensive) as guessing the course of the stock market, there is an excellent case to be made right now that the direction is down, down, down.
First, deflation, or an outright decline in the level of prices, is already afflicting parts of Asia, and is beginning to affect us here. When deflation is the worry, investors don’t demand heavy protection against rising prices in the future, and financial assets that pay any interest at all become alluring. So interest rates drop.
Second, as the crisis deepens and international stocks, bonds and currencies become riskier, Treasury securities, denominated in dollars, get more and more attractive as a safe haven from the storm - especially at a time when gold has lost its luster. When investors pour money into bonds, they are, in effect, saying, “I’m not choosy about what rate I get paid, just give me some security.” So, again, interest rates drop.
Deflation is a phenomenon we haven’t seen in this country in 60 years, but it’s a strong possibility. Last Friday, the government announced that the producer price index - based on payments to factories, farms and other businesses - was down 1.2 percent for the first 11 months of the year, compared with a gain of 2.6 percent for the same period in 1996. The last time the PPI fell for an entire year was in 1986, but that was strictly the result of plummeting oil prices.
Meanwhile, consumer prices are rising at less than 2 percent - perhaps as little as 1 percent when distortions are removed. And, the analyst Wesbury notes, “Over the past three months, “real’ or inflation-adjusted retail sales have fallen at a 3.5 percent annual rate.”
Why? First, there seems to be glut of things in the world - overinvestment has bred overproduction - in autos, semiconductors, clothes and more. The worst case is Asia, which is now suffering the consequences. But deflation can be exported, and that is what the Asians are doing, shoveling their cheap goods (made even cheaper by currency devaluations) in our direction.
For consumers, price declines can be wonderful. But for businesses, they can be devastating. A reasonable scenario is that, as prices fall, so will the rate of growth of corporate profits. Debt may become harder to service. Losses could ensue, then layoffs, then misery.
While, in the short run, this plot would be terrible for stocks, it could be delightful for bonds. Economist A. Gary Shilling, admittedly a fanatic on the subject, believes that long-term Treasury yields could drop below 4 percent.