Please Note: Blog posts are not selected, edited or screened by Seeking Alpha editors.

Wrestling With The Fixed Income Conundrum

The following analysis is part of a consulting project prepared last week for the fixed income portfolio of a not-for-profit client. I believe it provides helpful background for all investors puzzling over what to do to improve yield in a historically low interest rate environment.

The fixed income market has become highly polarized as major parts of the world financial system--even sovereign countries--are in danger of insolvency. Governments and central banks are exerting massive efforts to keep banks and countries flush with liquidity to ward off runs on banks and sovereign defaults. So far they have largely succeeded. But the debt problems are worsening and the world economy is slowing, making rescue efforts far more difficult. It is a realistic possibility that the best efforts of governments and central bankers will fail, that major financial entities will default and that serious repercussions will be felt throughout the world. Risk averse investors must evaluate the potential effects on their assets, should that scenario unfold.

The growing recognition of that possibility is evident in the increasing volume of assets invested in fixed income securities providing a negative yield. Trillions of dollars are now invested in securities providing no return or even a negative return. Clearly, many highly sophisticated investors are opting for the return of their money rather than a return on their money.

At the other end of the spectrum, higher yields are available to those willing to accept varying degrees of risk. They range from 200+% returns on Greek government debt to low single digit returns on high quality domestic corporate debt.

The Federal Reserve has made no secret of its desire to "force" (their word) investors out of risk-free securities into riskier holdings. In a multi-year low interest rate environment, many investors, in desperation, are fulfilling the Fed's desire and seeking returns in riskier investments. Unfortunately, the Fed does not stand ready to bail out investors, as they did major banks, should realized risks result in losses.

The only way to increase return is to assume more risk. Risk-free return is virtually non-existent. One can increase return by buying lower rated securities. Of course, the lower the rating, the greater the risk that interest or principal will not be paid. On almost all fixed income securities, return increases as the period to maturity lengthens. Price volatility also increases, the longer the time to maturity. At today's super-low interest rates, significant price declines can occur on longer maturity bonds if interest rates rise.

Let me use the 10-year U.S. Treasury note as an example. That security had a yield of 2.42% nine months ago, 3.22% just over a year ago, 3.75% just over a year and a half ago and 4.01% a little over 28 months ago. If interest rates rose back to those levels in exactly the amount of time it took them to decline to the present level, the loss to the investor--even including interest paid--would be 7% in nine months, 12% in a little more than a year and 14% in a little over a year and a half. If rates should rise back to where they were in early 2010 in an equivalent amount of time, each $1 million so invested would be worth less than $880,000 toward the end of 2014, even after counting the interest earned.

Rising interest rates destroy bond value. In a rising interest rate environment, inflation, which erodes purchasing power, is typically present as well. In the last rising interest rate cycle, which lasted for over four decades from the early-1940s to the early-1980s, no diversified bond portfolios beat the returns on risk-free cash over the full period, and no fixed income returns kept pace with inflation. The last three decades have been the most productive for fixed income managers in U.S. history. That period has lasted so long that virtually no fixed income managers today have any appreciable experience managing assets in a rising interest rate cycle. Another one is coming; the only question is how long it will take before it starts.

While extreme levels of debt throughout much of the world are exerting a deflationary effect today, the massive amounts of new money being created by major central banks could eventually lead to inflation--even severe inflation. In their academic classic, This Time Is Different, Carmen Reinhart and Ken Rogoff examine 800 years of financial crises throughout the world. A great many of them unfold with governments attempting to inflate away debt problems. Central banks today appear to be attempting that solution. Severe inflation, and the destruction of bond portfolios, were often the result of such action in the past and could be again.

Many investors suspect that they or their managers would be able to spot rising rates before they did too much damage. For most, that's an unrealistic assumption. In recent months, Spain and Italy have experienced rapidly rising rates more than once. From August to November of last year, rates on 10-year debt rose from below 5% in both countries to above 6.5% in Spain and above 7% in Italy. Encouraging words from central bankers led to the retreat back below 5% in both countries. As investor confidence waned, however, rates again rose from below 5% in both countries in March to above 7.5% in Spain and above 6.5% in Italy last week. Huge losses resulted in those bonds. No one knows whether rates will descend again from here or just keep rising. It has to be a very nervous moment for managers and investors in those bonds. Is that even remotely relevant to investors in the United States? Former Federal Reserve Board Governor Bill Poole recently said that when you look at the numbers, we're just a few years behind Greece. Our rates will stay low only as long as investor confidence remains. So far investors trust the Fed, despite its checkered past record. With ongoing trillion-dollar-plus deficits, a pending "fiscal cliff," two major political parties at loggerheads, a banking system still exposed to European debt problems and the possibility that China could, for political reasons, stop buying U.S. debt, that confidence could erode quickly.

It is reasonably likely that rates can stay low for a while, even for a couple of years more, as the Federal Reserve currently intends. Such a condition, however, is by no means certain. It ultimately will depend upon investor confidence, and not just in this country. Running deficits above $1 trillion per year, we are dependent upon foreign buyers in great volume to keep interest rates low. Such buyers could disappear quickly should our economy weaken significantly, money printing become even more aggressive, our debt appear out of control or our political parties remain unwilling to deal with serious long-term debt issues. While I believe the reward for remaining in fixed income securities is severely limited, except at very high risk levels, the risk of loss is very high. Rates will rise again and possibly strongly; the question is when. At present levels, it's a dangerous risk/reward bet.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.