I was recently watching the National Geographic Channel and they were discussing the rattlesnake. It seems that over the course of millions of years of evolution that the rattlesnake has developed, it is now incapable of striking and biting someone without signaling their distinctive calling card. However, once the rattlesnake’s tail has been rattled, all bets are off. It is a clear warning sign that danger is lurking.
In the financial services world, I wish that bond funds came with such a distinct warning. For although there are multiple warnings available to investors that we may be at the beginning stages of a bond bubble, the warning signs appear to be too subtle. This is evidenced by the fact that investors continue to pour money into bond funds.
According to Strategic Insight, bond fund flows should exceed $300 billion in the year 2012. Another $30 billion flowed into bond funds in October, setting the stage for annual net intake in excess of $300 billion. Domestic stock funds continued monthly net redemptions in the amount of $15 billion, despite capital appreciation.
The reason that bonds are dangerous at this point is that interest rates are so low and bond prices so high that there is little room left for gains. In fact, for the first time in decades some companies are offering a dividend yield that is higher than the interest rate that they pay on their bonds. The dividend yield is calculated by dividing the amount received in dividend by the stock price.
To put it another way, you could purchase a piece of company ownership represented by a stock share and receive the same income as you would lending the company money. However, the stock also receives the potential added benefit of any stock capital appreciation over the next decades. In early December 2012, the average S&P 500 stock annual dividend (monthly) was slightly over 2%, while the average AA rated company bond yield (daily) was just under 2%.
The bond yields have decreased so low for companies that they often borrow below the stated inflation rate of 2.2%. Effectively, investors in these low yielding bonds are actually losing purchasing power.
This is the way the bond market rattles its tail. Be forewarned.
The companies understand the benefit of such low rates and are flooding the corporate bond market with bond offerings. This year, the value of the bond sales by companies should break the 2009 record of over $1 trillion according to data from Dealogic.
The loudest noise from the bond market rattling its tail comes from data according to Barclays. If interest rates rise by just one percentage point next year, the average bond issue in the year 2012 would lose 5.12% of its value.
So what should investors being doing with their money? What they should always do. Diversify their overall portfolio holdings and ensure they have enough money allocated to ownership in the great companies of the world known as stocks. The percentage of U.S. households that have financial assets in stock ownership has fallen to approximately 38% from as high as 50% in 2000, according to the Federal Reserve.
A more balanced portfolio approach is required for most individuals so they may be able to achieve the various goals that they have set for themselves while attempting to maintain their purchasing power. Consider yourselves warned – listen for the rattle!