Market Commentary for the week of August 30, 2010

Are bonds alright?

With stocks offering very little in the way of a “sure thing” investment return lately, one might think that the bond market, traditionally an excellent alternative to the run-and-gun high risk platform of equities, could be a more sensible option for investors.

Such is not the case, however.

Although money flows do indicate that the last few years has seen a measurable uptick in assets in the bond market, today’s historically low interest rates have many wondering whether the relative security of fixed-income is worth the non-risk?  Indeed, in a climate of credit defaults, budget deficits, and the spectre of inflation and rising rates, this allocation choice might ultimately be the wrong gamble.

To be sure, today’s uncertain economy makes any long duration commitment, equity or fixed-income, a very high risk endeavor. 

In particular, price sensitivity in the bond market (that is, the inverse-relationship between price and the direction of rates) could adversely affect net-return for “safe haven” bonds, having exactly the opposite consequence than originally intended.

With rates near their long-term low inflection point, my work postulates that the only logical direction for rates in the next half-decade is “up.”  If that were the case, its impact upon retirement money, life style, and portfolio valuation could be disastrous, if not planned for in advance.

Execution strategy.

My clients might have noticed that our fixed income durations are quite short, unlike the last optimum yield opportunity we had for long-duration investing in the mid-90’s.

Because of the economic uncertainty of our time, it is easy to see why investors choose to avoid stocks.  But with the confluence of factors I briefly mentioned above, even that thought process might not be entirely correct.  The numbers do not quite yet indicate that equities are a safe bet, I concur.  The last two years of economic and political conflict have surely diminished enthusiasm for risk-taking, and rightly so.  Earnings, demand, and capital gains are all muted, at best.  Average annual returns in major global indices have been horrible since 2007, with last year being an exception, and not looking any better in 2010.

The symbolism of such under-performance might be a greater deterrent to new investable assets than the facts, but it’s tough to counter human nature.

As I scan available inventory and yield opportunities, I am struck by the dearth of potential in fixed income relative to equities.  This, I believe, will have deep reverberating consequences for our portfolio allocation models, as well as life style choices for clients looking at “safety of principal” as their primary objective.  It might be necessary to establish new chronological benchmarks, or valuation expectations, to attain personal goals or ideal return.

The best way to address today’s economic inefficiencies is to segment goals and assets into risk and risk averse execution strategies and to care less about 24 hour investment cycles in favor of longer-term, and more realistic, options.