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Bond Bubble?

Bond Bubble?

As interest rates have spiraled downward over the past decade, driving bond prices upward, many in the financial media have suggested that bonds and other fixed income instruments should be shunned and that bonds have entered “bubble territory.” With all of this discussion going around, it is important to understand what constitutes a bubble and what type of assets are affected by these events.

A bubble is typically defined as the aggressive appreciation of an asset far beyond a reasonable estimation of intrinsic value. One of the most memorable bubbles of the recent past was the so called “dot-com bubble.” During the late 1990s through early 2000, technology stocks appreciated to levels that could not be supported by fundamentals. The tech-heavy Nasdaq reached an all-time high of 5132 in March of 2000 before declining by almost 80% to 1108 in 2002.  Although there has been significant recovery in the Nasdaq, those who invested at the peak of the tech bubble over ten years ago, would still need to see the index appreciate by 90% just to get their original principal back! The problem as an investor is, if the decline is too great, the probability of timely recovery is remote and actual wealth destruction (as opposed to paper losses) takes place.

A bond is a much different type of asset than a stock or other capital asset as it is a contractual obligation to re-pay a loan at the end of a defined period of time. A stock by contrast involves no contractual obligation and the owner of such an asset is only entitled to the earnings after all other stakeholders have been paid. Therefore, the value of a stock at any time is subject to many more variables than a bond and is based on the perception of what those earnings will be at some point in the future. A bond by comparison, assuming the borrower/issuer is not bankrupt at the end of the contractual period, must return the principal amount owed in full. This fact makes the value of the bond much more ascertainable than that of a stock since at least as a bondholder/lender, I have a legal claim to an absolute value at a definitive point in the future. Therefore, since the ultimate value of a bond is known and there is no reasonable expectation of receiving more than the principal value at maturity, bonds can never really appreciate to levels that would constitute what we typically consider to be a bubble. 

The other argument often made today is that given low interest rates, investors should only buy very short-term bonds (if they buy bonds at all) as interest rates are sure to rise at some point in the future. The problem with this type of analysis is that it doesn’t take into consideration the opportunity cost of significantly less interest in the early years. Take for example, a U.S. Government bond issued at 3.4% (yield as of the date of this writing) with a ten-year maturity. One might argue that 3.4% annually is a paltry amount to accept over a ten year period and that one should shun this investment in favor of a very short-term instrument that would benefit from steadily rising rates.

Let’s examine this by contrasting the benefits of a 10-year U.S. Government bond paying a fixed 3.4% versus a two-year U.S. Government bond at the current .6%. Let’s assume that interest rates will rise 1.25% every two years such that the two-year bond in the example above would begin at .6% and would be renewed at 1.85%, 3.1%, 4.35%, and finally 5.6%. Many people would opt for the short-term bond in this example, but if the calculations are done, the better investment (assuming a ten-year holding period), would be the 10-year U.S. Government bond at a constant 3.4%. In this example, the 10-year U.S. Government bond held to maturity would generate $3,000 more in total income than the bond renewed every two years at subsequently higher rates.

What this example teaches us is that one should always run the numbers when making decisions as opposed to making assumptions or subscribing to conventional wisdom. The more important consideration is to make certain that the investment is made within the context of the proper time horizon and liquidity needs.

In summary, we are not of the belief that bonds as an asset class are in a classical “bubble,” nor do we believe that one should only opt for ultra short-term instruments. At MutualWealth, we continue to view bonds as an important asset class that has proven over time to diversify risk and generate a consistent stream of income. Although bonds may suffer through periods of rising interest rates, they will continue to serve a purpose in portfolio diversification and income production. With respect to strategy and individual security selection, we believe we serve our clients best by making investment decisions at the margin based upon actual analytical analysis as opposed to generic philosophical presumptions. As always, if you have concerns about the interest rate environment and the potential impact on your investments, please feel free to contact us at any time.               

Shayne Nagy, CTFA
Senior Vice President
Trust and Investments 


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Personal Banking Security Measures for the 21st Century

clientuploads/21st-Century-Securitysquare180.pngMany of us are constantly connected to the online world these days. This means that the potential is there for our computers and personal information to be compromised which greatly increases the risk of ID theft and financial fraud to occur. However, by taking some basic precautions you can significantly reduce the risk of your computing environment being compromised. Following these simple guidelines should help your computing environment become more secure:

Keep your computer and software up-to-date

Keep your computers and network equipment secured with the latest software updates and enable automatic updates whenever possible.  This includes updates to third party applications such as Java and Adobe Products.  

Use hard drive encryption

In the event your machine is lost or stolen, drive encryption can prevent others from accessing the data on your hard drive.  The purpose is to encrypt or scramble your data on your machine so that it can only be read with your encryption key.Many operating systems offer drive encryption.  Microsoft offers Bitlocker and Apple has FileVault. There are also other third party encryption offerings.   

Enable your firewall

Think of the firewall to your computer as the fence around your property.  If there were multiple holes cut in the fence, it wouldn’t be very useful at keeping people out.  Firewalls are typically enabled by default on Windows machines, but double check to make sure it’s on.  Here are instructions to do so if you are using Windows 7. Only allow necessary applications inbound access through your firewall. The same principles apply to your network firewall. 

Configure your screensaver

Set an auto-locking screensaver so your account gets locked out after a few minutes.  This is useful if you forget to lock your machine when are away from it. On Windows machines this can usually be done by pressing the “Windows Key” and the “L” button simultaneously.

Make your passwords stronger

The longer and more complex the password, the better.  At least 16 characters with a combination of upper and lowecase letters, numbers, and special characters is a best practice.

Configure your router

Use the strongest wireless security available (currently WPA2-CCMP) with a long and complex password for your wireless network. Disable WPS on your wireless router for greater security.   

 


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If you suspect that your personal financial information has been compromised, call MutualBank Customer Support at 800-382-8031.


 

Monday, April 7, 2014

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Bond Bubble?

Bond Bubble?

As interest rates have spiraled downward over the past decade, driving bond prices upward, many in the financial media have suggested that bonds and other fixed income instruments should be shunned and that bonds have entered “bubble territory.” With all of this discussion going around, it is important to understand what constitutes a bubble and what type of assets are affected by these events.

A bubble is typically defined as the aggressive appreciation of an asset far beyond a reasonable estimation of intrinsic value. One of the most memorable bubbles of the recent past was the so called “dot-com bubble.” During the late 1990s through early 2000, technology stocks appreciated to levels that could not be supported by fundamentals. The tech-heavy Nasdaq reached an all-time high of 5132 in March of 2000 before declining by almost 80% to 1108 in 2002.  Although there has been significant recovery in the Nasdaq, those who invested at the peak of the tech bubble over ten years ago, would still need to see the index appreciate by 90% just to get their original principal back! The problem as an investor is, if the decline is too great, the probability of timely recovery is remote and actual wealth destruction (as opposed to paper losses) takes place.

A bond is a much different type of asset than a stock or other capital asset as it is a contractual obligation to re-pay a loan at the end of a defined period of time. A stock by contrast involves no contractual obligation and the owner of such an asset is only entitled to the earnings after all other stakeholders have been paid. Therefore, the value of a stock at any time is subject to many more variables than a bond and is based on the perception of what those earnings will be at some point in the future. A bond by comparison, assuming the borrower/issuer is not bankrupt at the end of the contractual period, must return the principal amount owed in full. This fact makes the value of the bond much more ascertainable than that of a stock since at least as a bondholder/lender, I have a legal claim to an absolute value at a definitive point in the future. Therefore, since the ultimate value of a bond is known and there is no reasonable expectation of receiving more than the principal value at maturity, bonds can never really appreciate to levels that would constitute what we typically consider to be a bubble. 

The other argument often made today is that given low interest rates, investors should only buy very short-term bonds (if they buy bonds at all) as interest rates are sure to rise at some point in the future. The problem with this type of analysis is that it doesn’t take into consideration the opportunity cost of significantly less interest in the early years. Take for example, a U.S. Government bond issued at 3.4% (yield as of the date of this writing) with a ten-year maturity. One might argue that 3.4% annually is a paltry amount to accept over a ten year period and that one should shun this investment in favor of a very short-term instrument that would benefit from steadily rising rates.

Let’s examine this by contrasting the benefits of a 10-year U.S. Government bond paying a fixed 3.4% versus a two-year U.S. Government bond at the current .6%. Let’s assume that interest rates will rise 1.25% every two years such that the two-year bond in the example above would begin at .6% and would be renewed at 1.85%, 3.1%, 4.35%, and finally 5.6%. Many people would opt for the short-term bond in this example, but if the calculations are done, the better investment (assuming a ten-year holding period), would be the 10-year U.S. Government bond at a constant 3.4%. In this example, the 10-year U.S. Government bond held to maturity would generate $3,000 more in total income than the bond renewed every two years at subsequently higher rates.

What this example teaches us is that one should always run the numbers when making decisions as opposed to making assumptions or subscribing to conventional wisdom. The more important consideration is to make certain that the investment is made within the context of the proper time horizon and liquidity needs.

In summary, we are not of the belief that bonds as an asset class are in a classical “bubble,” nor do we believe that one should only opt for ultra short-term instruments. At MutualWealth, we continue to view bonds as an important asset class that has proven over time to diversify risk and generate a consistent stream of income. Although bonds may suffer through periods of rising interest rates, they will continue to serve a purpose in portfolio diversification and income production. With respect to strategy and individual security selection, we believe we serve our clients best by making investment decisions at the margin based upon actual analytical analysis as opposed to generic philosophical presumptions. As always, if you have concerns about the interest rate environment and the potential impact on your investments, please feel free to contact us at any time.               

Shayne Nagy, CTFA
Senior Vice President
Trust and Investments 


Contact a Representative Today

Back to Education Resources

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