People and Money

The world is awash in money now. US dollars held overseas are the monetary base for the world and provide foreign central banks with the capability to increase the supplies of their own local currencies. This is particularly true for China - it needs dollars to support the yuan, which would otherwise likely be deemed valueless, as currencies of dictatorships usually are. The world is awash in Euros and yen, too.

Signs of this are everywhere in the financial pages of major newspapers - from FT: "Sovereign bond markets in developing countries have seen a record $129bn in new deals so far this year ... Emerging market yields narrowed to 2.57 percentage points over US Treasuries on Monday compared with 3.5 percentage points a month ago ... Indonesian five-year bond yields, for instance, have fallen to 3.77 per cent. "

Who is buying Indonesia bonds for a puny 3.77% absolute yield ?

US corporate bond yields are very, very low, too, and bonds sales are huge. The huge high tide in money worldwide is finding its way into the bond markets, raising their prices and lowering yields. Spread measures don't tell the true pictures. The US five year Treasury rate is 2.4%. Core inflation is about 2%, so people are taking a real return of less than 1% locked in for five years.

Again, who is buying this paper at foolish absolute yields ?

One answer is the banks. Instead of making loans to productive companies, banks prefer buying securities. Obviously the regulators again missed something important. Why are banks becoming houses of securities instead of the engines of lending to productive companies that was their original purpose ? Likely because they are run by executives from Wall Street and not loan officers. And also because regulators actually give some preference to liquid securities in assessing that oft-cited number, "Tier 1 capital". Loans require more Tier 1 capital versus high grade securities.

The Fed and other regulators need to change this if small and medium sized business is to get the loans they need to grow.

Who else is buying those bonds ?

CLUE: What other "asset" is the world awash in ?

ANSWER: Older people - the grey hairs, the cue-tips. Demographics data show a greying Europe, a grey Japan and a very rapidly greying China. The US is somewhat greying as baby boomer hit retirement ages, but has some balance from decades of large immigration of young people and echos of the baby booms.

People in retirements - those with the money to retire - want safe yield from bonds and annuities for a large portion of their assets. Older people are buying them, or are investing in funds that do the buying.

Two major countries with youthful demographics are India and Brazil. I already mentioned China's grey hair. Russia is greying, too. That means BRIC is really a quite BI and a rather old RC. Very, very different demographics. The long term implications of this are huge.

What does this mean ?

Stop thinking about BRIC as a unit - that might have worked by accident in the first decade of the 21st century, but it won't work in second decade. Those nations are too different to lump together.

Don't buy those bonds. The absolute yields are too puny to risk locking up your money there. One is better off in blue chip, dividend paying stocks, gold and cash or TIPs. Worldwide inflation is likely coming and will likely be worst in the emerging markets. The convergence of world price parity eventually means serious inflation in those nations, or deflation in the US and Europe. Obviously the huge tide of money worldwide means it will be the former, not the latter.

IF you must buy fixed income, I'd stick to some fixed annuity type for a small/moderate portion of assets and put that money there strictly using time diversification. Use only AAA rated insurance companies and avoid high fees if possible. One benefit of this is you won't have the price risk worries owning bonds. The time diversification will give you some protection from inflation.

The only bonds worth buying are municipal bonds - 5% tax free is a great absolute rate now. But you'd better diversify hugely and stay away from anything with an unusually high yield. And use time diversification there, too. No CA, NV or AZ. No major cities. No Michigan. Nothing with event risk, such as medical centers in hurricane target zones. Get at least 5% and get 5 years call protection on a 20 year bond, or 10 years call protection a 30 year bond. Buy bonds with A ratings or better. No A- or lower.

I used to rule out FL, too, but now I realize it is not addicted to a graduated income tax. I'll look at the west coast - no east coast as it's a hurricane target zone. Hurricanes have a tough time curling around enough to hit the west hard.

Word of the Day

"Passe-partout" - noun [$10] (also "passepartout") from French for "passes everywhere"
Passepartout means 1. a master key; 2. a simple picture frame (esp. for mounted photographs) esp. one consisting of a piece of glass stuck to a backing by adhesive tape along the edges; 3. adhesive tape or paper used for this.
Sentence: Today's post poses questions and issues to consider, but provides no passe-partout for investors.