The Saver's Dilemma: Anticipating Yields

As a local at the Chicago Board of Trade, a wise trader once told me that the market aims to hurt as many speculators as possible. That's especially true, it would seem, when it's being manipulated by political, rather than economic, forces. Witness the market for government debt, which, despite efforts to keep rates lower, has suffered losses in 2009 as yields have climbed.

On Wednesday, Federal Reserve Chairman Ben Bernanke told lawmakers that "The Fed believes that a highly accommodative stance of monetary policy will be appropriate for an extended period." That means low interest rates, with the hope that will stimulate demand and pull the economy out of recession.

At the same time, Bernanke assures us that "we have the tools to raise interest rates when that becomes necessary to achieve our objectives of maximum employment and price stability." Indeed, there is almost uniform consensus that the historically low interest rates forced by the Fed will be unwound, perhaps as early as 2010.

For savers, this uncertainty coupled with today's miniscule yields presents a problem. Do they keep their assets in money markets while waiting for higher rates, or do they lock in today's meager long-term yields in the event rates drop or stay at low levels? Nobody feels great about buying a five-year CD that yields 2.94%, that is, unless they know the same five-year CD will yield 1.94% a few months down the line.

Japan also had a stock and real estate boom in the late 1980s. After boom turned to bust in the early 1990s, the government also took measures to stimulate the economy, with the Japan central bank setting interest rates at approximately zero. Not unlike the U.S., Japan also made extraordinary efforts to subsidize failed banks, leading to a slew of firms known as "Zombie Banks" — fundamentally insolvent institutions maintained only through government handouts. Kinda rings a bell, doesn't it?

Source: Rosewood Research

So far investors in Treasurys have lost money this year as rates have risen. And while I'm hard-pressed to allocate significant dollars to long term-bonds at a time in which government-fueled inflation seems almost inevitable, I'm struck by how many people seem to be waiting, wagering on higher rates.

Consider that Proshares UltraShort 20+ Year Treasury ProShares (TBT), the ETF designed to rise when long-term rates rise, trades significantly more volume and boasts nearly double the assets as iShares Barclays 20+ Year Treasury Bond (TLT), which owns long-term government bonds.

Knowing my old trading mentors warning about the market looking to hurt as many speculators as possible, I can potentially imagine a scenario in which the United States essentially follows Japan's post-bubble path, leading to years of trendless and choppy equity markets and ultra-low interest rates just at a time in which older investors are reaching for income. While it seems impossible today that rates could go much lower, in 1992, with the 10-year Japanese Government bond yielding 5%, I sincerely doubt many investors thought it would be below 1% 10 years later. The Nikkei 225, which closed at 38,957.44 on Dec. 29, 1989, traded this week at 9700 — a drop of 75% over almost 20 years.

One approach fixed-income investors might consider is the barbell strategy, which we first outlined more than five years back. The barbell strategy is named for the shape it creates on a chart of maturities — splitting your bond allocation between very short-term and very long-term maturities. The short-term investment provides the liquidity, while the long-term maturities afford the majority of the yield. The net effect is to create an intermediate-term return with considerably more flexibility.

If rates rise, investors are able to use both the short-term liquidity and income from the longer-term bonds to reinvest in securities with higher rates. If yields drop, as they did in Japan, an active investor can follow the trend by attempting to add additional long-term bonds on the way down.