sl12 trouble with the bubble
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23rd AnnualInvestment Conference & Luncheon
William Larkin, Jr.Portfolio Manager
Cabot Money Management, Inc.216 Essex Street
Salem, Massachusetts 01970800-888-6468 eCabot.com
Trouble with the Bubble!
Bond Bubble?
Part I
Analyzing Our Current Situation
US 10-Year US Treasury Security
Yield
Time
Yield is Inverse to Price
16% Peek
1.6% Today
Source: BB data pulled 9/4/2012
50 Years of Interest Rates
6.6% Ave
Our Interconnected Financial Systems
Debt Bubble
Housing
#3
Market Uncertainty Feeds Fear
House Bubble Burst Crisis-Averting ManeuversBanking Crisis
US Debt Purchases
#1#2
#4
#5
Cheapening the Value of Money
#3
The Fed’s Strategy = Financial Repression
The Fed’s Bond Buying Program
Cheapens the Cost of Debt Negative Real Interest Rates
Zero Interest Rates
Debtor Saver
Lowering Interest Rates Stimulates Economic Growth
Drives Down Borrowing Costs and Cheapens Savings
Highly Leveraged Enterprises and Households Can Enjoy AttractiveRefinancing Opportunities
Requires Government Intervention
Tends To Be Very Effective Over Time
Savers Are Forced To Seek High-Risk Opportunities
Do We Have A Bubble? Or Are We Funding Future Prosperity?
Double Dip Recession Global Recovery
Investment Behavior is Out of Balance
Greed vs. Fear
Returns vs. Principal Protection
Financial Doomsday or Work on Monday?
Fear UncertaintyReality
Peak
Trough
Early Recession
Late RecessionEarly Expansion#1
#2 #3
Gradually Improving Market Psychology
Late Expansion
Optimism
Enthusiasm
Euphoria
Unease
Denial
Pessimism
Panic
Capitulation
DespairHope Relief
Optimism
Economic Scenarios
Part III - Analyze The Current Situation
Source: http://politicalcalculations.blogspot.com/2011/11/180-years-of-us-national-debt-burden.html
Unfortunately We’re Been Here Before
War on TerrorIraq WarAfghan War
Bank Bailouts
Extending US Unemployment Benefits
US Auto RescueQE1
QE2
Payroll Tax Break
QE3?
Tax Policies
Fiscal Cliff
MedicareMedicaidSocial Security
Healthcare
US Debt DowngradeStructural Budget Deficit
Displaced UnemployedInterest Costs
Energy Policy
Bush Tax Cuts
American Recovery and Reinvestment Act
Foreign Policy
The US is Entering a Period Which Requires Rapid Changes
TARP
A Unique Macro Environment
Banking Capital Markets
Labor/Work DesignTechnology
Multi-National Companies
Supply Chain
Interest Rates
Transportation
Energy
Powerful Global Deflators
Energy
Resources Labor
Food
Materials
Fertilizer
Capital
Outsourcing Debt
Derivatives
Insurance
Made In China
No Environmental Rules
Competitiveness
Innovation
Product DevelopmentEfficienciesQuality Improvements
Global Integration
TradeSupply NetworksLegal and Regulatory Systems
Protectionism?Requires Investments
Ignoring Extreme Valuations
Housing
US Treasury Securities
2-Yr UST BondHighest 9/30/81 = 16.7%Average = 6.1%Low 12/30/11 = 0.24%
Lipper Taxable US Bond Inflows
Source: http://alphanow.thomsonreuters.com/2012/04/the-contrarian-signal-money-flows-favor-stocks-over-bonds/
Flows remain strong even with record low yields
The Mechanics of Bond Pricing Indicates Problems
Inflation Risks
Default Risk
Liquidity Risk
Reinvestment Risk
Duration Risk
Market Risk
Pricing that Ensures the Price of a Bond Adequately Compensates an Investor For the LevelOf Risks Associated with a Particular Investment
Infl. Expectations + Default Risks + Return = Price/Yield2.0% + 0% + 1.5% = 3.5%
I Can Just Hold My Bonds Until Maturity, Right?Wrong!
Current Price = $99.71 Yielding = 0.275%
Current Price = $98.84 Yielding = 1.75%
Current Price = $97.88 Yielding = 2.86%
+1% Change in Interest Rates, Price = $97.81 Loss = -1.9%, 8/4/2009 +2% Change in Interest Rates, Price = $95.95 Loss = -3.8%, 9/5/2008+3% Change in Interest Rates, Price = $94.13 Loss = -5.6%, 12/26/2007
+1% Change in Interest Rates, Price = $90.24 Loss = -8.7%, 7/8/2011+2% Change in Interest Rates, Price = $82.45 Loss = -16.6%, 2/4/2011+3% Change in Interest Rates, Price = $75.39 Loss = -23.7%, 8/15/2007
1% Change in Interest Rates, Price = $80.54 Loss = -17.7%, 8/2/2011 2% Change in Interest Rates, Price = $66.99 Loss = -31.6%, 4/5/20103% Change in Interest Rates, Price = $56.42 Loss = -42.4%, 3/14/2002
2-Year UST
10-Year UST
30-Year UST
Source: BB Valuation YAS basic % Price change a/o 8/22/2012
S/T
Int. Term
L/T
Is There A Bond Bubble?
The debt burden grows out of control and fiscal solutions fail to develop
The market comes to the conclusion that the debt has become unsustainable and demands a much higher return to offset growing risks
Bond yields rise causing harm to current holders that do not properly understand their potential loses
Debt Burden
Debt Crisis
Bursting Bubble
Part IV
Investment Solutions
Active Management Passive Indexing
Price InsensitiveOpportunistic
Vast Diversification Is Required
6.6%
4.8%5.75%
3.8%
2.3%
1.8%
1%
1%
0%4.0%
2.5%
Money Market
US Treasury Bonds
US Gov’t Agencies
Municipal Bonds
Mortgage-Backed Securities
High-GradeCorporate Bonds
Low-Grade Corporate Bonds
Fixed-Rate Preferred Securities
Sovereign Debt
Emerging Markets Debt
Bank Loans
High-Yield BondsConvertible Bonds
Foreign Infl. Adj. Securities
2.5%
High-Yield Municipal Bonds
5.75%
Zero Coupon Bonds
2.8%
Floating Rate Notes
1.0%Certificates of Deposit
0.7%
Australia Debt
3.6%
Canadian Debt
2.7%
L/T Corporate Bonds
4.25%L/T Gov’t Securities
2.8%
3.5%4.2%
Int’l High Yield
6.8%
Risk Management Requires Liquidity
Many Segments of the Bond MarketAre Truly Untested for Major
Redemptions
A Bond Market Vulnerability
The Biggest Risk Is Taking No Risk
Credit Risk
Broaden Exposure
Duration Risk
3 StrategyOptions
Default Risk
Global OpportunitiesExtend Maturities
Buy and Hold Doesn’t Work in This Environment
Index Funds have too much exposure to US Treasury Securities
Part V – Key Takeaways
Bond Strategies Require a Much More Diversified Approach
Uncertainty Requires Periodic Adjustments as Conditions Change
Liquidity Should be a Primary Risk-Management Practice
The Fed Has Removed Risk-Free Investment Options
Recoveries Can Occur Unexpectedly
Questions?
23rd AnnualInvestment Conference & Luncheon