Time for Income: Time for Bonds?

by: Marc Courtenay

Recently I heard an interview with David Rosenberg, and this is someone who has a better overview on the world economy than the vast majority of economists today. John Mauldin's web site www.johnmauldin.com introduces Mr. Rosenberg this way:

Chief Economist & Strategist David A. Rosenberg is Chief Economist & Strategist for Toronto based independent investment firm Gluskin Sheff + Associates Inc. Prior to joining Gluskin Sheff, David was Chief North American Economist at Bank of America-Merrill Lynch in New York and prior thereto, he was a Senior Economist at BMO Nesbitt Burns and Bank of Nova Scotia. Mr. Rosenberg has ranked first in economics in the Brendan Wood International Survey for Canada for the past seven years and was on the U.S. Institutional Investor All American All Star Team for the last four years.

This one interview made me glad I subscribed to "Conversations with John Mauldin". In the "conversation" another guest was Michael E. Lewitt who co-founded Harch Capital in 1991.

Mr. Lewitt has functioned as a research analyst, investment strategist and portfolio manager for HCM Group’s high yield fixed income and bank loan portfolios. Mr. Lewitt has worked in the securities business since 1987 and has substantial experience and knowledge of the legal, tax and financial issues involved in complex corporate transactions, corporate securities and hedge funds. Mr. Lewitt authors The HCM Market Letter, a monthly review of the financial markets and political world.

Listening to their conversation left me with many impressions, not the least of which are the following:

  1. This economic "contraction" [a.k.a The 21st Century Version of The Great Depression] will most likely last 5 years and perhaps as long as 10 years before all is back to an expansionary, full-recovery mode.
  2. Interest rates will most likely stay very low by historical standards for a long-time. The Federal Reserve has virtually insured that for the foreseeable future.
  3. As Mr. Rosenberg said, "safe income with growth" will be the most relevant investment theme in the current environment, and what he used as an example was the 3.5% current yield on the 10-year US Treasury bond.
  4. We are stuck in a deflationary mode at least for the next couple of years and perhaps longer.
  5. Quality, Investment-Grade Corporate Bonds still have much relevance even in the current contracting, high-unemployment, low interest rate economic malaise.
  6. There just isn't much more the government or the Federal Reserve can do to make things "all better" or to shorten the amount of time it will take for the economy to be back in a growth mode.
  7. The "economic engine" of the world will be shifting away from the US gradually and will be moving towards China and the emerging growth countries like Brazil and the nations of Asia over the next 5 to 10 years.

So my friends, for the first time in a long-time I believe it's time to consider safer, quality-oriented income investments like Treasuries, Investment-Grade Corporates and some Insured Municipal Bonds.

For my money I'd rather do this in the form of either Closed-end Funds or Exchange-traded Funds (ETFs). I'd like to share with you some that I've been considering and looking at very carefully. These are not recommended, although they are examples (in their holdings) of some of the bond-instruments Mr. Rosenbergy and Mr. Lewitt were referring to.

I list them below in no particular order and I encourage you to study them, their profile and holdings very carefully before you invest a dime of your money. They all pay very nice dividends/yields and most appear to pay monthly:

  1. iShares Barclays 7-10 Year Treasury Fund (NYSEARCA:IEF)
  2. iShares Investment Grade Corp Bond Fund (NYSEARCA:LQD)
  3. Blackrock MuniYield California Insured Fund, Inc. (NYSE:MCA)
  4. iShares Barclays Aggregate Bond (NYSEARCA:AGG)
  5. iShares Barclays 1-3 Year Treasury Bond (NYSEARCA:SHY)
  6. iShares Barclays TIPS Bond (NYSEARCA:TIP)
  7. Nuveen Insured Municipal Opportunity Fund Inc. (NIO)

This is by no means a complete list. There are a good number of mutual funds too that have these kinds of investments, but often they have higher internal expenses and are subject to liquidation factors etc.

Consider the fact that you might want to do some systematic investing (i.e. Dollar-Cost Averaging) because all these funds can go up or down and are very sensitive to the direction of prevailing interest rates. You can "put your feet in the water one toe at a time" and indeed that might be the best way to approach any bond fund.

By the way Ian McAvity whose newsletter Deliberations on World Markets is a must-read for all serious technical traders, had some keen observations on the bond market and interest rates in his July 8th publication. He wrote:

Bond market yields have recovered back to their pre-Crash levels, which I read as a marked sentiment shift for all that "fear capital" leaving, plus price is being driven up by inordinate supply. $515 billion is the Treasury estimate of net marketable borrowings this quarter!

It could be shocking to see some real AAA corporate bonds yielding less than corresponding Government maturities at some point this year. State & Local governments have evaporating tax revenues ballooning their deficits with Washington so far resisting any new bailout plans. California issuing IOU's because they're out of cash prompts complaints that the Feds will bail out Wall Street, but not California? (And if they did, the lineup of States right behind them would be a long one...)

The FED can manage short-term rates but excessive supply dependent on foreign buyers is going to cost more, which will exert a drag on any attempt at recovery in housing.

Imagine a broker offering you a 10 Year, 4% coupon denominated in a currency falling at 6% per annum rate. Current deficit projections are soaring and will force long rates up in coming years irrespective of the FEDs wishes.

These comments are relevant to this article and to the potential upside for AAA corporate bonds. Also, many pundits think the dollar will continue to rally in the short to mid-term and that we are in a deflationary economic environment.

My colleague and mentor John Mauldin recently wrote a terrific article on Inflation Vs. Deflation. His ending quote is a good one to end this article with as a "caveat" and I use it with John's permission.

The point I really want to make is that the inflation v. deflation story is the single biggest investment story right now and being on the right side of that trade will effectively secure your investment returns for years to come.

If I am wrong and inflation spikes, you want to load your portfolio with index linked government bonds (also known as TIPS for our American readers), gold and other commodities, commodity related stocks as well as property.

If deflation prevails, all you have to do is to look towards Japan and see what has done well over the past 20 years. Not much! You cannot even assume that bonds will do well. Recessions are bullish for long dated government bonds but a collapse of the entire credit system is not.

The reason is simple - with the bursting of the credit bubble comes drastic monetary and fiscal action. Central banks print money and governments spend money as if there is no tomorrow, and all bets are off.

Equities will do relatively poorly as will property prices. But equities will not go down in a straight line. The market will offer plenty of trading opportunities which must be taken advantage of, if you want to secure a decent return.

All in all, deflation is ugly and not conducive to attractive investment returns. It is also not what governments want and need right now.

With a mountain of debt hitting the streets of Europe and America over the next few years, as the cost of fixing the credit and banking crisis is financed, one can make a strong case for rising inflation actually being the favoured outcome if you look at it from the government's point of view.

The problem, as the Japanese can attest to, is that deflation is excruciatingly difficult to get rid of, once it has become entrenched. I am in no doubt which of the two evils I would prefer, but we may not have the luxury of choosing our own destiny. JohnMauldin@InvestorsInsight.com

Please Note: This article is to inform your thinking, not lead it. Only you can decide the best place for your money, and any decision you make will put your money at risk. Information or data included here may have already been overtaken by events – and must be verified elsewhere – should you choose to act on it. Please remember investments can fall as well as rise. And they will! - Advanced Investor Technologies LLC accepts no responsibility for any loss or damage resulting directly or indirectly from the use of this content.

Disclosure: Of all the funds mentioned in this article, I am currently only long TIP.