Here’s the second installment of the Bond Market Environment letter to clients by Denis Jamison of Strategy Asset Managers.  The first appeared yesterday.

debt without cost

Federal government borrowing has spiraled since 2008.  Total public debt outstanding–an amount that includes the notional amount owed by the Federal government to the various government trust funds–was $15.2 trillion at the end of 2011 compared with $9.2 trillion four years earlier.  Now, that debt is probably a trillion higher and exceeds nominal Gross Domestic Product.

You would think that much borrowing would put a huge strain on the federal government’s budget.

Well, it hasn’t.

In fact, for the year ended December 31, 2011, the interest payments on the federal debt were just 5% higher than in 2007, despite a 65% increase in the debt outstanding.  Moreover, the interest on the federal debt last year was just 1.5% of GDP.  That’s less than the 3%-plus drain on the country’s earnings during the second half of the Eighties and through the Nineties.

two reasons for this happy situation:

–first, the growth miracle during the Clinton Presidency provided a huge expansion in GDP while temporarily reducing the actual level of federal government debt.  And,

–second, the Federal Reserve’s zero interest rate policies begun in 2008 that reduced the interest cost of that debt from about 4.5% to less than 3%.

The trend in the cost of the federal government’s debt is glacial.  It takes a while for old bonds to mature and be replaced by new ones.  So the federal government’s debt costs will remain manageable for the next few years.  Investors should be very aware that the higher level of  federal debt to GDP plus the extraordinary low level of current interest payments could provide a severe headwind to economic growth down the road.

???

Bond investors have every reason to be confused.  They have enjoyed thirty years of high rates of return caused by steadily declining interest rates.  For various reasons, we experienced a secular decline in inflation since 1985.  Meanwhile, monetary policy amplified the impact of that decline on bond prices by steadily reducing the real rate of return (the nominal yield less the inflation rate).  We may have gone as far as we can down this road.  Real yields of most US Treasury securities are negative.  That’s happened before–in the Seventies.  Then it was caused by high inflation against a backdrop of loose monetary policy.  The inflation cure involved tight money, sharply higher interest rates and back-to-back recessions in the first half of the Eighties.

While Fed Chairman Bernanke draws parallels between the economic problems of the Thirties with those of today, he might want to consider the legacy of the Burns and Miller policies of the Seventies.  After the 1.5% inflation rates of the Sixties, these Fed chairmen didn’t think future inflation would be a problem, either.  And low interest rates seemed a good idea in exchange for economic growth.

It is likely bond investors will suffer a bear market someday–we just don’t know when.  For the moment, the music is still playing, so you have to keep dancing.

The only way to earn a real return today is to accept greater risk–maturity (or call) risk, credit risk, currency risk, liquidity risk and a lot of other risks that you won’t know are risks until something bad happens.  While I can’t pick the next winners (or losers), I can see a sector by sector return pattern created by the various waves of Federal Reserve policy.

By pushing short-term interest rates to zero, the Fed caused a huge rally in the US Treasury securities.  The gains now are limited because the real yield from these securities has reached zero.  Next, mortgages rallied as they were seen as a low risk alternative to government debt.  Now they, too, are exhausted because, at current price levels, prepayment losses are wiping out most of their coupon income.  That leaves maturity risk and credit risk still on the table for most investors.

maturity risk

The yield spreads between ten and thirty-year bonds are still attractive.  In the US Treasury market, that spread is about 125 basis points.  But the price risk for any change in interest rates is very high.  For example, investors in the current US Treasury thirty-year bonds would lose 15% if rates increase from the  current 3% to 3.5% ove the next six months.

credit risk

Assuming maturity risk isn’t to your liking, maybe the answer is corporate bonds.  Of course, there’s a lot of supply here because companies are busy selling new bonds to pay off old ones.  Maybe all this supply is keeping yields relatively high.  The spread between AAA-rated corporate bonds to ten-year US Treasuries is about 160 basis points.  If you can stomach BBB-rated securities, you’ll earn a 300 basis point advantage over governments.

Investors face difficult choices.  Old strategies aren’t working well in the current investment environment.  Unfortunately, when you step out on a new path, you never know where it will lead.