AT ANY GIVEN MOMENT, my first inclination isn’t to take a risk, but to reduce it. And for those readers who earn and spend U.S. dollars, one of the most important and least considered risks is that of a relative decline in the value of U.S. assets, from bonds to greenbacks.
So at a time in which most people are just starting to think about diversification away from the big domestic stocks, my sights are focused on a few more exotic locales, since it’s quite likely that the next big bull market will occur somewhere outside the U.S.
I’m not the only one making the call. In recent days, both Credit Suisse First Boston and Merrill Lynch have upped their allocations of non-U.S. equities, and although the pundits have a habitual knack for inaccuracy, I do believe this is one of the few macro calls worth heeding. A few weeks back we discussed some general opportunities in foreign and emerging markets. This time around, we’ll focus primarily on fixed income.
Because they are backed by the “full faith and credit” of the U.S. government, U.S. bonds are considered the world standard. Because they’re the most liquid and actively traded bonds in the world, U.S. Treasurys are the most often quoted barometer of interest rates. When most people refer to the bond market, they’re referring to the U.S. 30-year bond and, more recently, the 10-year note.
But while U.S. stocks have rebounded from September levels, domestic bond investors, even those who hold mutual funds, have taken a beating. For example, the Vanguard Total Bond Market Index fund (VBMFX), which seeks to track the entire market for investment-grade domestic bonds, is down 2% since mid-September. The Long Term Treasury fund (VUSTX), which tracks the 30-year bond, is down over 4%.
Using some basic technical analysis, it’s pretty clear the picture for Treasurys isn’t a pretty one. The yields on both the 10- and 30-year bonds have now crossed above their respective 200-day moving averages. Chosen because there are about 200 trading days in the year, this indicator is a widely used measure of intermediate to longer term trends. And while no technique is foolproof, it’s a good bet that interest rates, at least as far as Treasurys are concerned, will be going up.
That isn’t good news for the many investors who are increasingly focused on protecting principle and reducing volatility. A great majority of them will turn to bonds, specifically the supposedly “safe” Treasurys we consider to be risk-free. While bonds deserve a place in every investor’s portfolio, that place shouldn’t necessarily go to those issued by the U.S. government.
For over a year now, we’ve been pointing out that there’s more to investing than the huge and familiar. Even as the broad market has remained soggy, many investors have profited from everything from gold to small caps. These days, a similar subtlety is occurring in bonds, where emerging-market and foreign bonds have been outperforming U.S. issues in a big way.
According to Morningstar, the average international bond fund is basically flat year-to-date. Not burning up the charts, but still outpacing Treasurys. The average emerging-market bond fund, however, is up over 6% in 2002, with some up over 10%, and the entire group continues to look strong.
I love this country, but I’m making most of my new buys — especially in fixed income — in nondollar instruments. We may be staying at home and “cocooning,” but that doesn’t mean our money has to as well. Owning a foreign bond fund is one way to give your cash some “flash.”
A few weeks back, we mentioned both Templeton Emerging Markets Income fund (TEI) and Morgan Stanley Global Opportunity Bond fund (MGB) as potentially attractive closed-end bond funds. There are a few open-ended funds you might want to consider as well. Scudder Emerging Markets Income (SCEMX) is a no-load fund with well-placed bets in Russia, Brazil and Peru. It’s up 8% year-to-date. T. Rowe Price Emerging Markets Bond fund (PREMX) owns bonds from many countries, from Poland to Panama. It’s also a no-load fund, with reasonable expenses; it’s up 6.4% this year. And Payden Emerging Markets Bond fund (PYEMX), a tiny fund with only $34 million in assets, is up 4.9% so far this year. It sports a low expense ratio of less than 1%.
As to why U.S. bonds have done so poorly, some suggest the market’s expectations for faster economic growth (which would lead to higher interest rates, and, in turn, lower bond prices). There’s Enronitis and Greenspan, two convenient whipping posts.
I’ve constructed my own “lean” of why U.S. bonds might be beginning a tidal shift toward subperformance. A lean is your worldview. It’s your hypothesis, your expectation and your reason for making the trade in the first place. Whether it’s a fundamental data point, an economic indicator or a technical trendline, we all need a lean. It’s the confidence behind any trade.
My lean against U.S. bonds is focused around recent action not on Wall Street, but in Washington. Although President Bush campaigned on a platform of free trade and lower taxes, recent legislation seems more tilted toward economic strangulation, not stimulus. The federalizing (read: monopolizing) of airline screening, the endless investigations of Enron (ENRNQ) and the levying of new tariffs on steel imports are all factors in my recent distaste for U.S. bonds. I’m leaning on the notion that these are harbingers of bigger government, more regulation and consequently, higher taxes.
And what do higher taxes have to do with the value of U.S. assets? Those in Washington would do well to note that long-term U.S. interest rates started dropping the week of Aug. 18, 1988, when George Bush Sr. flipped the now legendary verbal bird: “Read my lips, no new taxes.”
The greatest vote of confidence you can give a country isn’t to wave its flag, but to buy its bonds. And although Bush Sr. eventually had to renege on his promise, the very fact he made lowering taxes such a clear and present national priority made one bullish on the future prosperity of the American people. Until the current administration can deliver a similar pledge, our nation’s bonds just might not be worth owning.
– Originally on Mar 11, 2002 by Jonathan Hoenig
