Bonds, A Future Investment Opportunity

Our bond market could offer some investment opportunities in the coming year if the Tea Party has its way. So here is a little insight in understanding the mechanics of bonds (as usual, I might get shot for over simplification).

If we were to buy a 30 year $10,000 bond at issue, at par, at an interest rate of 4.50% it would pay $450 each and every year for 30 years. Next year, suppose that interest rates jumped to 9%. Now if you were to buy a 10k bond at issue, it would pay $900 per year. That is double the interest rate of the bond bought the year before.

So if you are fleet of foot, you think, let’s sell the bond only paying 4.50%. Well guess what, the only bid you will get, will be for $5,000. It takes two old bonds to pay the same interest as one new bond. If you hold the lower paying bond to maturity, you will get your full 10k, but in the meantime, the newer bond by comparison paid twice the interest.

Several things affect the interest rate on a bond, the risk, and the length of the contract and market news. Another thing to consider is how low are interest rates? And will they go any lower Once you get to a yield of 3%, you can’t go much lower, but from there your risk of the rate going higher are almost a sure bet. Buying a 20 year Greek bond paying 33% interest means you get your investment back in 3 years (I'm lying, you're being robbed). The issuers of the bond are not paying that interest rate; it is the bond holders discounting the price, trying to unload a hot potato.

If we were to have a liquidity crisis, bonds offered for sale,would have few buyers, especially if they were small company bonds. As bonds prices drop, the interest rate paid, goes up.

Here is where the money is to be made. For example, a person purchases a 30 year 10K bond at issue with a 3% coupon, purchase price $10,000. Let’s figure that interest rates jump to 12% and that person needs to raise cash fast and decides to sell that 10K bond. The market would discount the bond to $2,500. That's the bond to buy. The new buyer gets 12% interest ($300) on his $2,500 investment. At maturity in 30 years, the bond pays $10,000, a capital gain of $7,500 on a $2,500 investment. The potential exists for higher rates; 12% though could be on the high side.

So as a rule of thumb with long term bonds, if interest rates double, the current value of the bond drops 50 percent. That could be the opportunity to take dollars out of the bank and buy bonds. Presently, interest rates are too low; risk and inflation have not been properly priced into rates. With the current budget crisis, the bond market is like a sleeping dragon---a loud Tea Party could wake it up.

As a side note of Interest

I have a sitemeter at the bottom of my blog and it gives me info on my viewers. I clicked on this one viewer in Washington DC and got a bit of a surprise, I just had to take a picture. Welcome to my blog whoever you are. Very few people use Apple computers.

Freeze The Debt Ceiling

Why raise the national debt level? Congress is not going to tax everyone more to make up the difference. It just gets put on bar tab, to be paid at a later date, someday (200 years from now). The phrase “Kicking the can down the road,” is the new euphemism in town. Reality is not about raising the debt ceiling; it’s about keeping the punch bowl full and the party going.

If Congress doesn’t increase the debt ceiling, our government has to face reality. You can wish, but if you don’t have the cash, it is only a dream. Our dreaming is over, reality is a necessary event. Below is a pic from from my blog dated 4/6/08 about bubbles, the big one is still there.


Of course, there is one item that needs to be considered. The Federal Reserve could be sitting on a giant Ponzi scheme that is invisible. Technically they give cash to banks and companies like AIG for collateral. So it is a zero sum game if the Fed sells the collateral (in theory)(but it could be worthless).The US government owns all of Fannie and Freddie’s real estate. The underwater home owners now hand the keys back to the tax payer. An extra 6 trillion hidden here would be a surprise that could change the color of an IRA fund manager’s underwear.

Obama the other day was pontifying “Raise taxes on the rich and rewrite the tax code to lower everyone’s taxes.” ---Sounds like a religious miracle in progress. How can you do both? The phrase “Used Car Salesman” comes to mind. Obama reminds me of the guy pimping his wife for drinking money. He comes home after partying and gets mad when his wife offers him the same rates everyone else paid.

What is happening in Greece is a little different. If they issued 3 percent long term bonds, these are probably trading for about 15 cents on the dollar. So if the IMF went in and bought 100 billion of them, it might cost them 15 billion face amount. But they could turn around and gift them back to Greece at 30 billion when they mature. It’s a little like your home going up for auction for nonpayment and your brother-in-law buys the place for peanuts and lets you live in it with the agreement that you pay him back. It keeps his sister happy and the jerk she married, on a leash.

The Congressional mentality, is to borrow until we can’t afford to pay the interest on the debt. That concept reminds of the two boys that were warned of the evils of masturbation, they were told it caused blindness. The one kid turned to the other and said, "Lets do it until we need to wear glasses." The real discussion right now revolves around serious cuts during the rest of Obama’s Presidency and it doesn't look like there are any. These proposed 10 year plans,are an euphemism for "Not on my watch."

The debt limit should be frozen where it is. Let’s stop this madness now. The Geithner claim that our debt rating will be hurt is pure hog wash. Our government debt is the benchmark for the rest of the world’s securities. Raising the Debt Limit allows the Treasury to be able to sell to the Federal Reserve that extra trillion the government doesn't need yet. Bernanke (the Fed) will buy Treasuries in order to keep interest rate artificially low. The neat thing about the transaction, the Federal Reserve returns back to the Treasury the dividends paid by the Treasury on the bonds held by the Federal Reserve. These purchases keep rates artificially low. Thus the bills purchased and held by the Fed cost the Treasury nothing.

Refusing to raise the debt limit, doesn’t change the final outcome. It’s just going to happen sooner, rather than two years from now. Our government is broke. Without the "New Money," the Fed cannot keep interest rates low by buying Treasuries, rates will have to rise. Greenspan and Bernanke will take the blame for this when the history books are written. They offered a flawed painless solution to a very painful problem. Unfortunately economists are more like coroners; they are better at diagnosing what went wrong and why, after the fact.

To a majority of Americans "The Economy" is just a concept, little understood. The "Group Think" is that Congress can fix what is broken. Congressional solutions are a little like trying to use your clothes dryer to dry the kitchen dishes and glassware. When the buzzer goes off, you can rest assured that everything is dry! You end up getting what you were promised, but it's not quite what you had in mind.

Unintended Solutions

Governments worldwide try to run their economies and regulate the interaction of their citizens. Most of the time the people are smart enough or are forced into an action that defeats the State's intended outcome.

We have the European Union of PIIGS trying to get out from under all of the burdening debt. Who gets to pay their bills? How do they get out from under the burden? The young can pick up and move to another country. This exacerbates the problem; these were the very people the countries were counting on to pay future taxes.

Students in the US can’t file for bankruptcy on college loans. Their paychecks are subject to garnishment. Even in death their estate will be used to settle those outstanding student loans. The obvious solution, pick up and move to another country. Our country invests in their future and leaves them only one option; emigrate and escape the chains that bind you.

States raise their sales tax rates. Now, everyone shops the local store to touch and feel the product. Then, they go on-line and buy it out of state. Retailers just love this concept.

Every year in the past, my wife and I got a customary 2 percent pay raise, and that didn’t happen this year. Our wages stayed the same, but just about everything went up in price. California increased the vehicle registration fees, so we sold that third car we hardly ever used. The cable company raised our rates for basic service, so we canceled that service. Raising prices or taxes does not guarantee increased income; you may end up with less. State governments during the Great Depression learned this the hard way.

The nations of our world economy have implemented financial smoke and mirror solutions to our present problems. They have little money saved in reserve. About the only thing we can draw from all of this, is that the expected government results, will not occur. As individuals, decisions will be made that will have far reaching results at the group level that were not anticipated. Net result, the politicians will be scratching their heads wondering where they went wrong.

Australia could become the new frontier for our young adults and anyone with a hell of a lot of student debt. Of course we need our young people to fight our wars and to work to help support our retired people (Social Security contributions). Kind of makes you wonder, where’s the incentive to stick around? Our manufacturing base left for foreign shores, our kids could be next.

The Buffett Mind Set

Warren Buffett suggests that we raise the National Debt limit. If you look at it his way, we can only run out of money if we stop printing it. CNBC’s Rick Santelli, part of the original Tea Party, thinks that now is the time to stop spending. So what if the government can’t pay all of its bills, it needs to live within our means. Not everyone gets paid, but we won't be kicking the can down the road to the next election. Two opposing views that are radically different. And of course in this country, the more money you have the more valued your opinion.

Total tax collections for the country equaled 2.162 trillion dollars last year. Anyone want to bet that this year won’t quite make it to that level?

Total expenditures equaled 3.456 Trillion. And figure another 800 billion that somehow never made it into the colorful illustrations. The word "Off budget," comes to mind. The "Net Interest" below needs to be added to "Other Mandatory" for a more realistic number. Somebody from Fannie Mae must be doing these visual aids.

Below is a graph plotting future debt payments, to progressively higher interest rates, using the new anticipated national debt level of 16 trillion dollars. As interest rates rise, there are fewer dollars left for real government operations. The "Game Over" point is where taxes collected are less than interest owed. Our debt burden makes us very vulnerable to any future interest rate hikes. [double click for a more depressing view]

Government financing will fall apart way before we hit 12 percent. At an interest rate of about 9 percent, Social Security and Medicare would no longer be 100% fundable. The thing to worry about, is that interest rates don’t just increase slowly. Greece saw an interest rate jump from 12 percent to 26 percent in seven months.

We are at a fork in the road. Rick Santelli makes a lot of sense, no new taxes and put government on a budget. We can't seriously expect to spend our way out of debt. Our other option is a financial train wreck, a year or two down the road. With an added benefit, we get to wipe the 16 trillion off the books and start over. Of course if you're close to retirement age, the words "Start Over" means you're going to need a shopping cart with 4 good wheels and a large cardboard box for the long haul. It wouldn't be so bad if my wife didn't hate camping.

The Under Funded National Debt

Last week Tim Geithner wrote a letter to Congress stating his opinion on why the national debt limit should be increased. Here are some excerpts from it:

I am writing in response to your letter of May 23, 2011, regarding the statutory debt limit. . . . . . .
The debate over the debt limit can seem esoteric, but a failure to resolve it in the near term would have painful implications for people in every walk of American life. It would have a serious impact on members of the Armed Forces who depend on paychecks to feed and house their families. Social Security recipients who subsist on their monthly benefits, veterans who rely on the government for their retirement and health care needs, and small business owners or employees who provide goods and services to the country.

In your letter, you suggest that the debt limit should not be raised, and instead the federal debt be “capped” at the current limit. You further propose that after the government’s borrowing authority is exhausted in August, the United States should for some indefinite period pay only the interest on its debt, while stopping or delaying payment of a broad swath of other commitments the country has made under the law. . . . . . . .

Even if the idea of “prioritization” were not so unwise, it would not be a mere exercise in “belt tightening,” as you suggest. The United States in now required to borrow approximately 40 cents for every dollar of expenditures. Your proposal would require cutting roughly 40 percent of all government payments. These deep cuts would be felt by all Americans, and they would risk throwing the economy back into recession.

Note his remark above, “The United States in now required to borrow approximately 40 cents for every dollar of expenditures,” kind of took me by surprise. Considering the present size of the deficit, it doesn't look as if it is a temporary thing.

Geithner goes on to state:

Under normal circumstances, investors who hold Treasuries purchase new Treasury securities when the debt matures, permitting the United States to pay the principal on this maturing debt. Yet in the scenario you advocate, in which the United State would be defaulting on a broad range of its other obligations, there is no guarantee that investors would continue to re-invest in new Treasury securities . . . . . . . . failure to pay non-debt obligations “would signal sever financial distress and potentially imminent debt default,” prompting the U.S. sovereign rating to be place on “Rating Watch Negative.”

If investors chose not to purchase a sufficient volume of new Treasury securities, the United States would be required to pay the principal on maturing debt, and not merely the interest, out of available cash. Yet the Treasury would be unable to make these principal payments without the continued confidence of market participants willing to buy new Treasury securities. Your proposal assumes markets would be unconcerned by our failure to pay other obligations. But if this assumption proved incorrect, then the United States would be forced to default on its debt.

The last two paragraphs seem to run contrary to supply and demand economics. A rise in T-bill rates would bring investors back. Presently, why are Treasury rates so low? Doesn't the risk of default imply higher rates? Credit card companies charge deadbeats around 30 percent.

How does raising the debt limit solve the threat of government default? It's nothing more than an accounting trick. A possible real solution, tax every man, woman and child in this country, an additional $1,000 per year (or deduct it from benefits received); this approach might eliminate the need to raise the National Debt level. And that’s not likely to happen.

This financial game being played in Congress is defined by rules, and as long as they play by the rules, the game can continue. In reality, the country is broke and the only thing keeping the government from defaulting is the extremely low interest rate on the National Debt. Our government is running on IOU’s. The 14 trillion in debt isn’t real; it’s too big to be real. True reality is that government check in your mailbox. Who gets the blame when the house of cards collapses? Naturally the Republicans, Obama gave them ample warning, raise the debt limit or else.

So today’s assignment kiddies, is to write down your net worth on a piece of paper. Now move the decimal point one place to the left. This is how you raise the national debt. The new figure is your equivalent buying power in todays dollars, at retirement. You didn’t lose a penny, but that’s how our daily newspaper went from a dime to a dollar.