Recently, “Fiscal Cliff” headlines have been dominating the media. As we wrote a few weeks back in “The Fiscal Charade,” we do not believe that any compromise reached on Capitol Hill will be significantly different than the changes set to take place in January 2013. Any deal will involve higher taxes which favor the Democrat’s platform, and spending cuts/entitlement reform per the Republican’s platform. Six of one, half dozen of another; we reach the same conclusion. However we feel that there is a much bigger problem at hand than the “Fiscal Cliff,” and that problem lies within the bond market.
Many investors do not realize just how big the bond market is. As of the 2nd Quarter of 2012, the bond market had $37.46 trillion outstanding debt. In comparison, according to the World Federation of Exchanges, the market capitalization of NYSE listed companies totaled $14.2 trillion in December of 2011. A big part of this size disparity comes from the perceived comfort that bonds bring. Some investors and their brokers prefer the safety of “guaranteed income,” thus they buy bonds. This may be a naïve and unsafe play going in to the coming years. From this point on, when we refer to “bonds,” we will be referring specifically to long-term fixed-rate federal debt.
Many investors (especially in 401(k) plans) hold bonds and do not even know it. Target Date Funds (Retirement 2020, etc.) usually have some exposure to bonds, and that exposure becomes greater and greater the closer the participant gets to retirement. Bond owners fail to realize that interest rates and bond prices vary inversely; if rates are at all time lows, bond prices are at all time highs. If traders were to trade bonds in today’s market, they would be buying or selling at near historic highs.
Why should you care? Well, aside from the fact that your broker or fund manager is trading bonds actively, you should care because it is quite easy for the value of your investment to diminish very quickly, all at the hands of the Treasury Department and Federal Reserve. We all know that the US National Debt recently broke $16 trillion. However, if the federal government were to allow interest rates to rise, let’s say from a hypothetical 4% to 8%, the value of the debt would be cut in half since rates doubled. Raising rates would result in outstanding debt losing its value (low interest rate products are not desirable when rates are rising) and the feds buying off the old debt and refinancing new debt at these higher rates. At some point, this will happen, maybe not under this administration, but inevitably this debt will be written down, and when bond prices fall they will fall sharply.
The savvy reader is probably thinking, “Oh well, if bonds are not the place to be and I want income, I will move to high dividend paying stocks like utilities companies or the like.” That would be a great thought, except for the tax implications. Interest on bonds is taxed as ordinary income, while dividends are taxed at a separate rate. If a “Fiscal Cliff” compromise on taxes is not reached, dividend taxes are set to jump from 15% to 43.4%, not to mention capital gains taxes are set to increase from 15% to 23.8% according to Forbes.
To recap: investors wanting an income generating asset can either buy bonds and lose out big time when rates begin to rise, or own high dividend stocks and be taxed to death. That leaves a couple of options for investors; sit on the sidelines and wait it out until the markets and fiscal policies become rational, or become more aggressive in looking for investments that can earn their portfolios the returns needed to ensure a successful retirement. Our bet is on the latter.
The general rule of thumb for professional investing is that the majority of market participants are on the wrong side of a trade or philosophy; a true Contrarian way of looking at the world. With mutual fund outflows at abnormal and inexplicably high levels, we see only good things coming for both US equities and for the US economy. However, we encourage all investors to be wary of the bond market; it might be time to reevaluate your portfolio’s holdings.