Tuesday, January 29, 2008

Commentary on current market rates

There have been some remarkable changes happening recently in the economy. Most interesting for me has been to watch what is happening to interest rates in the bond market. Consider it in these terms:

Let's say that you are a lender looking for a place to put your money. An organization comes to you and wants a 2 year loan. They have a lot of debt (about four to five times their annual income), but they have a perfect track record of paying back previous loans. They offer you 2.18% interest in exchange for a 2 year loan. You want to make a higher return? Well, in exchange for locking up your money for a longer period of time, they offer you a 2.78% interest on a 5 year note, 3.58% interest on a 10 year note, or 4.29% on a 30 year note.

Those are the current yields for government treasury bonds. Investors with deep pockets are currently locking up their money for 10 years for a 3.58% return. Inflation is currently sitting at 4.08%, and few analysts are expecting that to get better any time soon. It seems incredible to me that these investors are willing to lock up their money for 10 or even 30 years at rates which are unlikely to produce a positive return after accounting for inflation.

So, why are investors sinking billions of dollars of investment money into notes with returns that won't even keep pace with the rate of inflation? The answer is that economic uncertainty and market turmoil have pushed people into a flight toward safer investments. A return of zero after inflation is better than loosing your shirt.

So, what are you to do as an investor? Well, I would argue that blindly following the rest of the market is not a winning strategy. Often investors act with a herd mentality and push investments to unreasonable extremes. This explains the frequent bubble - crash cycles in various markets. Eventually, however, investments return to a long term rate of return based on their underlying value. This economic principle is known as regression to the mean, and it holds true in every aspect of investing. Putting money into bond funds at these low rates seems unlikely to be a long term winning strategy. When interest rates do go back up the value of these bond funds will plummet adding additional insult to the already low rates of return.

At times like this it is beneficial to have some money on the sidelines. That way, when one market gets way out of whack you can invest at bargain prices with the hope that, following the principle of regression to the mean, you will make money as the market corrects itself. So, as the real estate and stock markets fall there will be the potential for money to be made by those that have some money on the sidelines. Think of it in terms of the S&L crisis of the 1980s or the Great Depression. If you invested then you would have bought at discount prices right before real estate and stock market booms. There will be lots of short term volatility in the coming months, but patient disciplined long term investors can benefit from the market discount the volatility provides.


Tom said...

I just noticed the rate for Zopa CD's dropped from 5.1% to 4.5% in response to the fed rate drop.

Tom said...

Wow - federal interest rates were just cut again.

adfecto said...

You need to realize that the money invested in government bonds is not locked for the time period equal to the maturity. There is a very liquid secondary market for government bonds. If a person (or institution) needs their capital back the just sell the bond. This may result in some loss of capital depending on future bond rates, but the money is not locked in as if it were a CD or Prosper loan ;-)

Tom said...

Adfecto - I sure can't wait until Prosper has a secondary market!