This month, I’ll tie together two adages I learned years ago. The first comes from my father, who’d repeat for me a lesson learned from one of his engineering professors: “You can’t push on a string.” This is another way of saying to always use a tool the correct way. A string can do lots of good things, but it cannot transmit a force applied at one end to the other end.
The other is from Marty Zweig, a frequent and entertaining guest on the TV show “Wall Street Week with Louis Rukeyser.” One of Zweig’s overarching investment principles was: “Don’t fight the Fed.” Zweig meant that, when the Fed has its foot on the easy-money accelerator, it’s time to climb aboard the stock market fast train. Conversely, when the Fed is tightening the short-term interest screws, it’s time to lighten up on risky assets.
Now that the Fed has held short-term interest rates at zero for more than two years and promises to do so until at least 2013, Zweig’s adage is less useful for the stock market investor than it would typically be. But let’s look at how the Fed’s actions are affecting the bond market and investments that are tied to it.
Bonds produce returns by virtue of the interest they pay. If you invest $10,000, the issuer will promise to repay that amount on a certain date in the future and pay you interest for the right to use your money during the interim. The total return on your bond investment can be calculated on the day you purchase it by using as factors how much you pay, the interest payments you receive and how long the issuer gets to use your money. Although bonds now come in a wide variety of flavors, they’re all variations on this simple theme.
Because the market value of a bond falls when interest rates rise, the bond investor must take into account the risk that interest rate increases will drive the market value of his or her bonds lower. One widely used rule of thumb is that the best estimate of future interest rates for any given period is the current yield on bonds due at the end of that period. For example, the most recently issued 10-year U.S. Treasury bond bears a coupon, or face, interest rate of 2.125 percent. Assuming it was issued at par, or 100 cents on the dollar, the best estimate of interest rates for the next 10 years in August 2011 was 2.125 percent, at least for safe Treasuries.
Yields on other bonds typically follow Treasury yields, but at higher levels to reflect the additional risk that the issuer won’t be able to pay its debts. This is often referred to as the “credit spread.” Before the 2008 meltdown, yields on investment-grade (safer) corporate bonds were commonly somewhat less than 1 percent higher than those on Treasuries of equivalent maturities. These spreads shot up dramatically in 2008, but while they’ve narrowed since, they still remain close to 2 percent. So the best estimate today of interest rates on high-quality corporate bonds over the next 10 years is about 4 percent.
Here’s the takeaway: If you’re satisfied with a 4 percent yield, buy bonds. If you’re looking for better returns from bonds, you’re pushing on a string. Look elsewhere.
Insurance companies have traditionally been among the largest purchasers of good-quality corporate bonds. Using sophisticated actuarial techniques, an insurance company can estimate when it’s likely to need to pay out claims on the life insurance policies for which it’s accepting premiums. The same goes for fixed annuities, where the insurance company knows how much and when it must make future payments to the annuitants. Using that information, they then use bonds to match their assets against these liabilities, knowing that, with bonds, they can predict with mathematical certainty the investment return on the pool of premiums they’re holding for future claims.
If you examine any life insurance policy illustration, it will always say something to the effect that the numbers shown for premiums and cash values are based on recent experience but aren’t guaranteed. The guaranteed earnings are usually found in smaller print and, almost always over the past three decades, have been around 4 percent. Here’s the problem: If 4 percent is all the insurance company can earn on the bonds it buys, it can’t pay 4 percent to policyholders. Insurance companies have expenses, often including generous sales commissions, which run at least 2 percent annually (and probably closer to 3 percent), leaving only 1 percent to 2 percent for policyholders and annuitants.
In September, the Fed announced “Operation Twist,” its latest attempt to juice the economy. This refers to a policy of selling the short-term Treasuries it holds on its balance sheet and purchasing longer-dated bonds. The Fed is trying to reduce long-term interest rates to make it more attractive for businesses and homeowners to borrow money. But for every individual aided by this policy, others will be hurt. The Fed’s zero short-term interest rate policy has drastically reduced income for those who count on CDs to provide income. The Fed’s latest policy to lower longer-term interest rates will reduce the income available from annuities and insurance policies, along with other bond-derived sources.
So don’t fight the Fed and don’t try to push on a string. Avoid, for now, purchasing fixed annuities—except those that give you back your principal in five years or less. If you’re interested in “permanent” (cash value) insurance, consider instead a term policy that has a conversion option you can exercise sometime in the future, when bond yields are more attractive and after the Fed has quit messing with the bond market.
