Bonds, especially Treasuries and municipal bonds (munis), are a major component of American retirement portfolios, be it pensions, IRAs, annuities, or mutual funds.
The recent sharp fall in bond prices, which started last November, has sent tremors through fixed income markets. With an apparent end to the 30 year old bull market in bonds, it may be time to look at alternatives.
How Safe Are Treasury and Municipal Bonds?
Treasuries, munis, and other bonds may have hit their highs early last fall. Since then -- about the same time Quantitative Easing 2 (QE2) kicked in -- things have been mostly downhill for bonds.
Treasuries have the full backing of the U.S. government, removing default risk. But . . . U.S. government obligations are ramping past $14 trillion (with no end in sight). Anyone who looks beyond the end of their nose must wonder where all the money is going to come from -- if not the printing press. The catch is: The Fed dares not stop the stimulus for fear of another deflationary collapse.
Since 2008 the Fed has responded by taking short term rates to zero and now, with QE2, buying longer term Treasuries. Unfortunately, this buying has not lowered rates as intended (indeed they have risen). It has, however, goosed commodity and equity markets worldwide.
Munis, though not guaranteed by the U.S. government, have had an historically low default rate. Tax exempt interest make munis especially desirable with seemingly higher future taxes coming. The fly in the ointment, of course, is the dismal state of state and local governments. If munis start defaulting in 2011 as Mereidith Whitney predicts this market will crumble further. Even a small number of defaults will cause a loss of faith -- driving muni prices down.
U.S. Monetary Policy and Egyptian Riots
Here is an additional concern:
There is an almost certain relationship between U.S. monetary policy, bond prices, commodity price inflation, and international stability. As you look at this table, roll your curser over the various commodities -- paying special attention to grains. All the charts that pop up (excepting gold which spiked earlier) show rapid commodity price inflation -- just in the last 3 months! Are we seeing a hint of hyperinflation here?
Now, the price of gold or silver may not matter much to most of the world's population. But for the 90% who spend near half (or more) of their income on food, you can bet the price of these commodities matters! It matters a lot! Food prices are said to be a major contributing factor to the unrest in Egypt (and now elsewhere).
This article is not meant to debate the veracity of the above relationships, but if true, the Fed may stop QE2 for humanitarian and global stability reasons despite U.S. consequences. With the Fed not buying bonds, interest rates will move toward market driven levels -- presumably rates up and prices down.
Consider the Former Canadian Income Trusts
If you are looking for income and inflation protection look at the former Canadian Income Trusts with their large oil and gas holdings. In the past, these income generating trusts have been very rewarding for investors. Now, with corporate conversion due to tax law changes, many (but not all) are keeping their historically high distributions.
Established, rich in land, here are some candidates to consider: Enerplus (ERF) and Pengrowth Energy (PGH) are active in horizontal drilling on their acerage. Penn West Petroleum (PWE) is Canada's largest conventional light oil producer, Nal Energy (NOIGF.PK) and Freehold Royaltis Ltd. (FRHLF.PK) have large acerage positions across Canada.
There are others. The companies vary as to how they handle their assets. Some are oil heavy, some gas heavy, some actively exploiting reserves while others just maintain current positions. Do your own research and exercise due diligence as appropriate to your situation.
The big plus, of course, is these companies own actual oil and gas assets -- they are not just paper promises. There is no commodity more in demand than energy. Canada is probably the most stable place in the world. The country is democratic, well educated, and sitting on vast oil, gas, gold, fertilizer and fertile crop land resources. You can't do much better.
A Cautionary Note
Like all dividend paying equities, Canadian oil and gas stocks do not have the regularity fixed income has. Distributions are subject to volatile oil and gas markets. This can be quite unnerving if you are used to the clockwork regularity of bond payments. You must ignore short term fluctuations and hold for the long term. Timing the market is difficult.
Keep a Fixed Income Position
I feel fixed income instruments such as Treasuries can still play an important role in retirement planning. You want to hedge against deflation. Gary Shilling, for one, sees a strengthening U.S. dollar and falling interest rates.
Bonds are at increasing systemic risk as the U.S. continues to pursue inflationary monetary policies -- you must protect yourself! Retirement investments, with income generating equity component, preferably backed by natural resources, are a must. On the other hand, Treasuries are your best defense against deflationary collapse (which cannot be ruled out, though seems unlikely at this time). Look at both fixed income and asset based equity income.