Marvin Appel, PhD, and Brian Hufford, CPA
Although bond investments are generally regarded as safe, the current economic climate makes long-term bonds riskier than many conservative investors appreciate. In this article, we discuss the dangers that now face long-term bondholders and recommend conservative strategies to employ while awaiting safer times ahead.
Current price stability is keeping interest rates low
You may recall that bonds pay a fixed amount of interest semiannually for the life of the bond. At maturity, the initial amount of the loan (generally $1,000 per bond) is repaid. As a result of this arrangement, bondholders fare well if prices remain stable or decline, but suffer if inflation heats up. The reason is that the purchasing power of a fixed amount of income (for example, $50 per year for each $1,000 invested) is preserved or even improved in an environment of stable or declining prices, but the purchasing power of a fixed income is eroded by inflation.
Bond investors, of course, understand this and demand income sufficient to compensate them for the perceived inflation risk. So, during periods of high inflation, long-term interest rates have tended to be high, while during periods of price stability, long-term interest rates have tended to be low.
Currently, inflation is under control. Consumer prices have been increasing at between 2 and 3 percent per year — the lowest levels since the early 1960s and well below the postwar (WWII) average rate of almost 4 percent. As a result, interest rates also are near 40-year lows.
Inflation shows signs of picking up
The current, benign environment of economic growth and low inflation may not be sustainable. The government is running large deficits, which by itself is a stimulant to the economy. In addition, our currency is weakening. (The dollar is now making record lows against the Euro.) This will make imports, on which American consumers depend heavily, more expensive. In part due to government spending, and in part due to very low interest rates, our economy is growing more rapidly than at any time since 1984 according to the latest quarterly data.
All of these developments would be expected to push prices higher. This has already happened with important commodities on which our industries depend, including oil. Overall commodity prices are up more than 8 percent in 2003. Crude oil is up 25 percent since the President declared hostilities to be over in Iraq. Gold, its price reflecting investor sentiment regarding inflation and world stability, is up 15 percent this year.
Implications
The economic environment — robust growth, low inflation, low interest rates — now resembles the situation of the mid-1960s, so it might be useful to see how bond investors fared back then. Interest rates and inflation started climbing in 1966, generating losses to corporate bond investors that year. Part of the cause was budget deficits incurred to pay for the war in Vietnam. Trade deficits eventually led the United States to sever the link between the dollar and gold, driving the value of our currency down and boosting import prices.
Successive waves of inflation beginning in 1969, 1974, and 1979 bumped interest rates higher each time, generating losses for bond investors who had bought when rates were lower. But the positive aspect of the inflationary cycle for bond investors was that investors with uncommitted cash to invest had the opportunity to lock in attractive interest rates.
If you accept the notion that current economic trends appear to mirror developments in the late 1960s, then inflation must be considered a danger to your bond investments. Next month, we will discuss defensive bond strategies that will protect you if inflation does heat up.
Dr. Marvin Appel is CEO of Appel Asset Management. He holds a degree in biochemical sciences from Harvard College and earned his MD in 1991. He is coauthor of Systems and Forecasts. Contact him at (516) 487-7146 or [email protected]. Brian C. Hufford, CPA, CFP, is president of Hufford Investment Advisory Programs, LLC, and Hufford Financial Advisors, companies dedicated solely to helping dentists secure solid financial planning and safe investment strategies. He can be reached at (317) 848-4987.
