SPENCE Asset Management

Interest Rate Time Machine April 2011

Investing in bonds over the last thirty years could be described as a case study in dramatic change. In the early 1980’s interest rates reached historic peaks. However, nobody sent out postcards telling investors to put all of their income investments in high grade, long term, non-callable bonds. The ultimate would have been to lock in those historic interest rates. At that time, most savers were pretty satisfied staying short-term with their money market accounts. In those days, thanks to gross imbalances in the economy, money market accounts were providing double digit interest rates and savers were reluctant to tie up their money in longer term bonds for only slightly higher rates of return. With the benefit of hindsight, we know that buying long term non-callable bonds would have been the best course of action for the income investor.

For thirty years since, with but a few interruptions, interest rates have been on a steady decline. And today, for the better part of three years, money market account returns have been near zero. As the first quarter of 2011 ended, the yield on a non-callable ten year U.S. Treasury note was 3.45%. The meager current interest rate environment poses a number of questions. Why are rates so low? Will rates change anytime soon? What will inflation do to purchasing power? What is a safety-oriented income investor to do?

We can recall no time when income investing was so perilous. Looking back nostalgically at the early 1980’s might be an interesting walk down memory lane but it won’t increase our income. And the reasons why rates were so HIGH back then may or may not provide much relevance to the discussions today. The early 1980’s was a period when poorly managed government policy created tremendous imbalances in the financial system. Reckless Federal Reserve policies during the 1960’s and 70’s led to runaway inflation rates. And by the end of the 1970’s the financial markets reflected those imbalances. Bond investors were tired of being burned by free falls in their purchasing power. They eschewed U.S. treasury bonds to the point that their yields rose into the mid-teens. And during that time frame, places like the U.S.S.R, Eastern Europe, China, and India were still floundering with hapless state-managed economies that produced no excess savings to absorb U.S. debt issuances.

In some ways things are different these days, but unfortunately not in the recklessness of our Federal Reserve Board. We now have a global bond market, and it has yet to wake up to the reckless Federal Reserve policies even though the policies mirror the mistakes of the 1960’s and 1970’s. As of yet, the global debt markets are not demanding significantly more yield from U.S. Treasury bonds. In recent years, China has been financing the U.S. borrowing binge. China has taken advantage of its labor pool and created an economic growth machine that is now a receiving tank for a sizeable portion of U.S. wealth and U.S. treasury securities. Other nations buy our debt too, but for the last year or so, the Fed has been using reserves it does not have to absorb our debt offerings.

Why haven’t interest rates gone up? Mainly because the U.S. government, through actions by our elected officials in the White House and Congress, are doing everything they can (through Federal Reserve and Treasury Department) to artificially hold down America’s borrowing costs. In effect through our government’s actions, all savers around the globe are being forced to subsidize the American policymaker’s almost insatiable need to continue to issue low interest rate debt. How long will this continue? Nobody really knows. Knowing some of the reasons why rates are low is fine, but the big question is: What should an investor do with this knowledge?

First, we think it is always foolish to reach for higher yielding income securities in the hopes of receiving more income. Our fundamental view is there is NO FREE LUNCH in investing for income. Higher yields involve serious risk taking. We also think it is a bad idea to buy long term bonds with rates at historical lows. Unfortunately, we also think it might be very costly to sit in money market accounts at zero rates of return while hoping for higher rates. It is possible that the current low interest rate environment might persist for years. Now that we have told you all the things we DON’T want to do, let us tell you, given all the facts as we see them, what we are willing to do in managing accounts for income.

Our preference is to buy callable intermediate term bonds with interest rate STEP provisions. This means we want to find bonds where the provisions require the issuers to INCREASE the interest rate paid to us if the bonds are not called. In effect, this strategy involves some protection against rising rates as well as providing a greater rate than we could earn in a money market account. Since there is no free lunch, it is not a perfect strategy- rates could definitely rise faster than the interest rates on the bonds step up or rates could remain at historic lows and the bonds could be called. However, it is a strategy we are comfortable with given the fact that interest rates have declined dramatically over the last thirty years, the income needs of our clients continue on, and we do not possess an interest rate time machine.

Jim Spence, Eric Walton

The information contained herein is for informational purposes only without regard to any particular user’s investment objectives, risk tolerances or financial situation and does not constitute investment advice, nor should it be considered a solicitation or offering to investors. To determine if investment in a Separately Managed Account with Spence Asset Management is an appropriate investment for you please call 1.800.230.1840.

Investment Advisory Services are offered through Spence Asset Management, a federally registered Investment Advisor. Investment Advisory Services offered through IAR’s of Spence Asset Management, a Registered Investment Advisor to all residents of the United States.

The views expressed here are those of Spence Asset Management and are subject to change with market conditions. The information contained in this newsletter is derived from sources believed to be accurate. You should discuss any legal, tax, or financial matters with the appropriate professional. Neither the information presented nor any opinion expressed constitutes investment advice or a solicitation for the purchase or sale of any security. Market forecasts cannot be guaranteed. Past performance does not guarantee future results.