Income Investors... Here's The Biggest Mistake You Can Make

Alexander Green
by Alexander Green, Chief Investment Strategist

Income Investors... Here's The Biggest Mistake You Can Make

by Alexander Green, Chief Investment Strategist

Monday, February 1, 2010: Issue #1187

According to Crane Data of Westborough, Massachusetts, the 100 biggest money market funds are currently paying an average of .05 percent.

This is the smallest return that money markets have ever paid. To put it in perspective, at the present rate, it would take more than a 1,000 years to double your money.

I'll go out on a limb here and suggest that may be a tad longer than your personal investment horizon.

Here's what not to do in response to this...

Chasing Higher Returns... In the Wrong Place

Investors who panicked during the market meltdown a year ago and have hidden in cash investments for 12 months are really suffering. Not only did they get stung in the market's selloff, they've earned next to nothing in cash and have missed an enormous rally in corporate bonds and stocks.

If you go back in history and look not just in the United States, but also in global fixed-income markets, the gap between long and short-term rates has rarely been greater. Translated into the parlance of the bond market, the "yield curve" has seldom been steeper.

So in order to escape today's microscopic yields, mutual fund money-flow reports show that many income investors are shoveling money out of their money market funds and into long-term U.S. government bonds - and the funds that invest in them - because they're higher yielding and "safe."

Uh-oh...

When Interest Rates Rise, Bond Investors Will Pay the Price

What many of these investors don't understand is how badly they can - and almost certainly will - get whacked when interest rates start to rise.

The Federal Reserve and other central banks around the world have maintained an extremely loose monetary policy in order to restore the health of the global financial system. And while we're still only in the fourth or fifth inning, things are definitely looking up.

(Those who want to debate this point can argue with the world's financial markets, not me.)

Eventually, Federal Reserve Chairman Ben Bernanke (who just got reappointed to a second four-term in office) will start taking short-term rates higher. That will probably happen in the second half of this year. Longer-term rates will rise, too. In fact, they've been on an upward trajectory since late November.

Yield-hungry investors - the same ones who over-invested in stocks two years ago when they thought the coast was clear - are now plowing into Treasuries at precisely the wrong time.

How can we be sure?

  • Because when bond yields rise, prices fall. The effect is magnified for longer-term securities, so a 30-year bond will fall in value much more sharply than, say, a six-month Treasury bill.
  • Of course, a money market fund will benefit as interest rates rise. But even if the Fed lifts rates by 100 basis points - a full percentage point in layman's terms - the yield on a money market will still be only 1%.

It's tough to imagine reaching your investment goals at that rate. However, investors in Treasuries face an even bigger problem...

America Is About to Lose Its Triple-A Membership

Because of long-term structural deficits in the United States, Treasuries may soon see a ratings downgrade.

Everyday investors will see this as a stunning bolt out of the blue. But they shouldn't. The writing has been on the wall for a long time.

Congress has spent the past three decades spending money like sailors with four hours of shore leave. Eventually, the piper must be paid. And it will come in the form of our sovereign debt losing its vaunted Triple-A credit rating.

Want someone to blame? Contact your Congressman and your two Senators. Tell them you know what they've been up to lately: http://www.usdebtclock.org/

In short, there are plenty of great places to invest for yield right now. I can assure you that long-term Treasuries are not one of them.

Good investing,

Alexander Green

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