Tuesday, December 8, 2009

How Can the Threat of a Ratings Downgrade Send Prices of a Bond Higher? (It Can't.)

The following excerpts from a Bloomberg.com article demonstrate anew the uselessness of much of what passes for financial reporting:

Dec. 8 (Bloomberg) -- Stocks, gold and oil fell, Treasuries advanced and the yen and dollar strengthened as credit-rating companies highlighted the risk of government deficits and German industrial production unexpectedly dropped. . .

Moody’s Investors Service said today deteriorating public finances in the U.S. and U.K. may “test the Aaa boundaries.”

Of course, for the Moody's comments to make sense, gold should have risen and the price of Treasury debt fallen.

Not that rising prices for Federal debt make a lot of sense, but this is what has happened in slow-growth Japan and may represent the Fed's exit strategy. The Fed owns truly massive amounts of low-yielding mortgage-backed securities and if the 10-year Treasury goes under 2% with a stabilized if slow-growing economy, the Fed can be made whole.

The fact that essentially no one believes that this scenario is going to happen means that it is not priced into the Treasury market. Right now, par 10-year Treasuries do not yield what your broker tells you they yield, because there is zero reinvestment income. Thus they yield less than you think. On the other hand, zero coupon (or stripped) Treasuries trade cheap to par bonds, and probably yield around 4% with no reinvestment issues. Thus you may be able to purchase for $67.50 a zero coupon Treasury that will be worth $100 in ten years: an aggregate 50% return given 4% compounded annually. In five years, you will have a 5-year bond and if interest rates have not changed from now to then (who knows which way they will go?), you will have received more than a 4% annual return due to capital appreciation.

Zeros and strips are taxed on the annual unrealized interest, so taxable accounts interested in them should consider munis. For retirement accounts, most people are grossly underinvested in Treasuries and other highly secure income vehicles, and zeros/strips are a sensible part of a diversified tax-deferred portfolio.

No matter what tortured explanations for small prices changes the media propound to sell advertising and to induce people to generate commissions by trading.

Copyright (C) Long Lake LLC 2009

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