How to Time Bonds

John Mauldin | Thoughts from the Frontline
April 6, 2001

We are finally getting the bear market rally I have be writing about and hoping for. At least I think it is a bear market rally. Those who are buying this run must see something else Profiting From Greenspan and His Magic Rate Cuts:

Look for Rising Bond Values

Free Cassette Tape on Bond Timing

I got more positive response from the last e-letter on deflation than any letter I have written. I am still answering emails. But let me make one quick clarification before we discuss how to use this logic to your potential advantage. Also, at the end of this letter, I will offer you an opportunity to get a free cassette interview on bond timing from I did with Don Peters, a bond manager who has consistently been in the top 1% of bond managers in the country for the last 25 years.

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In a nutshell, my point last week was:

1. We are clearly seeing asset deflation around the world as stock markets drop.

2. We are seeing secular deflation in a host of basic commodity prices in the metals and grains, which means we are producing more than we can consume.

3. We are seeing competitive devaluation in currency after currency around the world as they attempt to keep their products priced low in terms of their currencies so as to prop up the export base.

4. We have a world-wide glut of capacity. The US is producing at only 80% of capacity, and much of the world is doing far less. There is very little ability for companies to increase prices. (Greg Weldon showed last week where purchasing managers are now seeing more lowering of prices rather than higher prices. This is a big switch in trends.)

The upshot of all this: I believe that Greenspan is going to have to cut rates a lot more than the Conventional Wisdom thinks to get this economy and the world back on track. The above deflationary pressures are a serious drag on the economies of the world. Of course, he has 500 basis points left to cut before he gets to zero, which in the real world is quite a lot (unless you are Japan).

Instead of the 50 or 100 points most analysts are now expecting for the rest of this year, because of the above cited economic pressures, I think we could see additional cuts of as much as 150 to 200 basis points! That still leaves us a long way from zero. Greenspan is expanding the money supply at a monstrous rate. Between rates cuts and money supply expansion, I do not think we will get into a deflationary spiral. Interest rates, in my opinion, could go a lot lower. The economy will recover in the second quarter, and indeed it may be the 4th quarter before we see a turn-around.

By they way, the above scenario is not good in the short term for stocks. Whatever move up we see in the next few weeks is a bear market rally. It means the recession lasts longer than most people think. But it will pass, and we will once again make money from a rising stock market. The bad news is that it will be rising from a lower point than most investors will be happy about.

So, what is one to do in the meantime?

The Greenspan Put

Pundits all over the country are touting the lowering of interest rates by the Fed as the Greenspan Put. They feel/hope/conjecture Alan is riding to the rescue of the stock market with lower rates. They see this lowering of interest rates as a fundamental effect which will magically pull stocks back up. It is the usual and predictable formula, and most of the time it works, as historical data readily reveals. As I said above, it will work this time - just not as soon as the talking TV cheerleaders and investment banking analysts think. Last Wednesday was not the bottom.

But there is one place the Greenspan Put is going to work that many investors are ignoring. Like a value stock with high dividends, I think the lowering of interest rates gives us the basic fundamental for an investment with high upside potential with a protected downside.

Today, I want to explore one other place we can find true value coupled with the possibility for solid growth: US Government Bonds. Last year, my favorite government bond mutual fund grew over 31%. I believe there is reason to believe we can see a repeat of this in the future.

First, let's remember that as interest rates go down, the net asset value of bonds go up (and vice-versa, of course). The longer the term of the bond, the greater the rise or fall. 30 year bonds will rise and fall far more in times of changing interest rates than short term bonds or notes. For instance, if rates on 30 year Treasuries drop 1% from where they are today, we would see a gain of about 17% plus the interest coupon. And on a special category of long term Treasuries called zero-coupon bonds, a 1% drop in rates would yield a gain of about 33%! A 2% drop would be a whopping 78%! (Of course, a rise in rates would work just the opposite and result in big losses!)

How Low Can Greenspan Go?

What would lead us to believe that interest rates are likely to fall even further in the next few years?

First, we are clearly in a period of economic slowdown. Factory orders are down, inventories are up, consumer confidence is down, lay-offs are up (almost doubling year-to-year in February), job advertisements are down 20%, inflation is going down, profits are going down, etc. and so are interest rates.

The mechanics of dropping interest rates are pretty simple to explain. In periods of slower or no growth, there are fewer people willing to borrow money and even fewer that banks are willing to lend to. Investors become concerned and move money out of stocks and into bonds and money market funds. In January, a record $140 billion gushed into mutual funds, but the vast majority of that money went to retail and institutional money market funds. In February, mutual fund investors withdrew $13.4 billion more from stock funds than they invested in February, while bond funds took in $2.3 billion.

In short, money may be on its way to becoming "cheap." Competition among banks and lenders for the good loans drives rates down, and as more money chases a fixed supply of government and corporate debt, buyers bid up the value of bonds.

In an effort to boost consumption and help lower business costs, the Fed reduces interest rates. You can bank on this: Greenspan will keep reducing interest rates until the economy is growing again. He can make 10 more 50 basis point cuts before he gets to zero. As we will see in a minute, from the standpoint of bonds, it doesn't matter if rate-cutting jumpstarts the economy. Falling interest rates are in the cards.

Secondly, as argued last week and above, we are getting ready to experience something entirely new to this generation: deflation. Many commodities and services are already seeing prices going lower, and if not for the costs of energy and tobacco, price inflation would be almost non-existent.

A slowing economy could take us from a period of low inflation into outright deflation. As I said earlier, the US is only producing at about 80% of capacity. It is well-known that the US consumer is the engine driving the world economy. But for the last few months, we are beginning to actually see imports slow down or contract in certain areas. This creates problems for other countries. Taiwan and Japan are both experiencing deflation. Japan actually had a trade deficit last month.

With manufacturing and service capacity around the world increasing, the ability of companies to raise prices is very limited in the face of stiff competition. Margins are eroding. Consumers are getting relative bargains.

There is a very real concern that billions of dollars of telecom bonds will be down-graded and/or defaulted upon. The collapse of these bonds could be a very deflationary drag upon the economy.

There is a school of thought in behavioral economics that runs something like this: consumer confidence is directly linked to job security. If I am confident that I am going to be getting my paycheck, then I can plan a budget and spend accordingly. But if I am worried, I start spending less and make fewer purchases which could cost me in the future.

We have seen lay-offs running about 100,000 per month for the last 3 months. February saw a 187% increase since last year this time. While over-all employment is still quite good, it does not help confidence when large lay-offs are on the front page every week. It does not help when "help wanted" ads are down 20%. That worry will slow spending. Less spending means companies have to cut their prices to move products.

Further, over $4 trillion in net asset value has been trimmed from the stock market in the last year. It is little wonder that investors are fleeing the stock market hills for the safety of cash and bonds. Just as the wealth effect induced people to spend freely, the lower wealth effect makes people feel like spending less.

Consider this: if investors want an inflation premium when they lend money thus driving up interest rates, what will happen in a period of deflation? The answer is simple: rates will go lower, especially if investors come to believe that deflation is truly setting in.

The Surprise in the Surplus

Finally, rates on long-term government bonds are likely to go down as the supply of long term bonds diminishes. In Alan Greenspan's recent testimony before Congress, he stated that there are $750 billion in long term securities that are not scheduled to mature before 2011. $400 billion is in Savings Bonds and similar debt, the holders of which are not likely to sell. There is currently $2.3 trillion in non-marketable funds for social security and the like. Since we "only" have $5.7 trillion in debt, there is actually only about $2.5 to $3 trillion or so that will be available for actual debt retirement. And since the bulk of the surplus will continue to be Social Security, this seriously reduces the amount of debt available to the public.

The surplus in 2000 was $237 billion, of which $150 billion was from Social Security. Projected surpluses run to $800 billion annually by the end of this decade. Even assuming that President Bush gets his full tax cut (which is phased in VERY slowly), there should be plenty of surplus left over to retire debt in the coming years. That debt retirement will presumably include long term bonds. But Greenspan's testimony gives us a clue as to a possible hidden profit potential.

There are thousands of funds, companies and government entities which by law are mandated to use government debt for certain functions. Foreign governments use US debt to back their own currencies or as part of their monetary policy. Finally, there are many investors who want to own government bonds in their portfolios, especially large institutional and pension funds.

The government is going to be the biggest buyer of US debt, first to use government bonds as the asset of choice for Social Security and secondly to retire the debt. What will they buy?

If they move too fast after the long term debt, they will drive bond prices up, so I expect early on they simply purchase short term debt as it becomes available.

The investing public, pension funds, institutions and other non-US governments which want to own US obligations will see that the only way to insure that they can continue to hold these instruments will be to buy longer term debt. As the supply of long term debt decreases, the price of long term bonds will rise.

So let's see if I have this picture straight. If the economy goes into the tank, Greenspan will keep lowering rates and bring long term rates down with them, thus increasing the price of long-term bonds. If the economy recovers, surpluses are likely to be larger than forecast and therefore mean a reduction in the supply of bonds, forcing down rates and increasing the price of bonds.

And to top it off, we are in a low inflation if not deflationary environment which will put further downward pressure on rates.

What could make rates go up? The primary risk is that for some reason, inflation begins to rear its ugly head and Greenspan decides to ignore it. Maybe the economy in future years once again "overheats" and Greenspan or his successor decides to slow us down by raising rates, although it is not clear that would affect long-term government interest rates. Presumably, if we are "over-heating" then that means budget surpluses are sky-high and we are retiring even more government debt, thus reducing the supply of bonds and presumably increasing the price. In any event, I am not worried about inflation returning this year.

In short, we may be in an environment where long-term bonds could be one of the best value investments for the next few years. (By the way, if we see a return to inflation, hopefully you will read about it in the Millennium Wave Online.)

Free Cassette Tape on Bond Timing

As interest rates drop, one of the best ways to take advantage of lowering rates is in long term bonds. For those who want to manage their own portfolios, the more conservative way is the American Century Long term government bond fund (BLAGX). Last year it returned 19.3%. For more aggressive investors, you can use the American Century Target 2025 Fund (BTTRX) which uses zero coupon government bonds. Last year it did 32.1%, but it is much more volatile and will go down much more if rates go up. American Century also has medium term bond and zero-coupon bond funds which should also do well for those who want to take less risk. (American Century 800-345-2021)

Now, as long time readers know, I am an investment advisor. I rarely mention or suggest an investment with which I am connected with. I do not want you to think my opinions are trying to sell a product. They may be right or wrong, but they are my opinions as free from bias as I can make them.

That being said, I want to call to your attention a bond manager who has one of the best track records in America, and which my firm represents.

Many investors like to have a professional look over a portion of their portfolio and do the worrying for them. Bonds, like stocks, go up and down in value. Deciding what the direction of interest rates will be in the future is difficult, at best. Compounding that difficulty is the possibility that events can change the economic climate quickly, and what seemed like a reasonable investment last month now is in difficulty. At times like that, it is good to have a seasoned professional in your stable of advisors.

Don Peters of Central Plains Advisors has been in the top 1% of all bond managers in the country for the last 25, 20, 15, 10, and 5 years (as ranked by an independent analysis firm) and one of my favorite investment managers. Over the last ten years, he has made 15% (annualized) simply using government bonds! Last year they were up over 31%! His secret? He uses government bonds as instruments for capturing capital gains and doesn't worry about the actual yield. That becomes "gravy". He moves up and down the yield curve trying to magnify the potential for gains in times of falling rates and hopes to minimize the losses in times when he thinks rates are likely to rise. If this sounds familiar, it is similar to what I have written about using high yield bonds. The best way to invest in high yield bonds is to find the times they offer capital gain potential.

With Peter's track record, you might well imagine that Don manages large portfolios for institutional clients. And he did. But a few years ago, he decided to retire. After a year, he realized he didn't like retirement and decided to once again manage money. But a non-compete clause keeps him from managing institutional money for a period of time. However, he can manage individual money. He takes accounts as low as $25,000.

Don and I did a cassette tape interview in late March in which we discuss bond timing and how he has been so successful. We talk in detail of his philosophy of using bonds as capital gain investments and not just as interest rate investments.

I am also now able to offer my high yield bond timing service to clients. I call it the Millennium Wave Total Return Program. We switch between three funds using a basic moving average approach. I have written a Special Report detailing this approach, what type of returns you can expect and what type of risk there is. The program is designed for clients who want the potential for something better than money market returns and are willing to take moderate risk. As I mentioned in previous letters. I think high yield bonds will offer excellent opportunity when the recession is over.

In the cassette interview, we talk about our Total Return Program and why Don and I believe that a combination of the two programs offers potential advantages to investors. The tape will be accompanied by complete information on the services of both don Peters and myself.

You can learn from this master where he thinks the bond markets are headed and why. It is free. You can get this tape by emailing me at John@2000wave.com or calling my office at 800-829-7273. If you email me, please remember to give me your address and phone number.

I will send you the tape and information on how you can open accounts with either Don or my Total Return program. If you are looking for an alternative to the stock market or money markets , but want the potential for more than money market returns, I think you should call or write today. If you would like to talk to me directly, I will be glad to do so.

Your Bullish on Bonds Analyst,

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