The 10-Year Mistake

by | Mar 31, 2004

With the Federal Reserve holding official overnight interest rates at 1.00%, the yield on the typical money-market fund is about one half of one percent, after management fees. With yields this low, you’ve got to be tempted to do something — anything! — to get more. That’s just what Alan Greenspan wants you to think. […]

With the Federal Reserve holding official overnight interest rates at 1.00%, the yield on the typical money-market fund is about one half of one percent, after management fees. With yields this low, you’ve got to be tempted to do something — anything! — to get more.

That’s just what Alan Greenspan wants you to think. It’s part of the Fed’s game plan to stimulate the economy, to force investors out of riskless cash-like shelters and into riskier investments like long-term bonds and stocks. Good plan. It’s working. But it has some serious pitfalls that you need to be aware of.

I cannot urge you strongly enough not to move out of money-market funds and into long-term Treasury bonds. Right now that’s the most tempting thing to do — and seemingly the safest — but it’s also the stupidest. Doing that is all risk and almost no reward.

Yes, yes, I know. The extra yield you can pick up in long-term Treasurys — without taking any corporate credit risk — is bigger now in comparison with money-market yields than at almost any time in history. The fed-funds rate is 1.00%, and the yield on 10-year Treasurys is 3.74% — a spread of 2.74%. After fees, the yield difference in similar mutual funds is about the same. As you can see in the chart below, there have been only a handful of brief moments (marked on the chart in yellow) when that spread has been any greater.

So who could resist dumping money-market funds and buying bond funds? If you’ve made this mistake, you’re not alone. Even some of my most sophisticated institutional bond-manager clients are making their own version of this mistake. They’re selling their short-maturity bonds and buying long-maturity ones. They say, “I have to do it. If I don’t get the yield of my portfolio up, I’ll get fired.”

I’ll try to prove to you just how shortsighted and dangerous that attitude is. Let’s look at it from a risk-reward perspective. What’s the most you can gain by selling your money-market fund and buying a bond fund? Easy — that difference of 2.70% in yield per year. But what’s the risk?

The risk is that even though the bond fund yields more, long-term bonds have the risk of loss of principal that money-market funds don’t have. How risky can long-term bonds be? Plenty.

For example, a 10-year Treasury bond will lose about 6 3/4% of its principal value if interest rates rise by 1.00%. In other words, if its yield rises from 3.74% to 4.74% — not a particularly large move, and one that can easily be expected from today’s low levels — you will lose 6 3/4% of your investment.

Now think about it: How many years would you have to earn that 2.74% yield difference in order to make up for a 6-3/4% loss? About two and a half years.

If you ask me, it’s about as certain as anything ever can be in the uncertain realm of investing that at some point between now and two and a half years from now, interest rates will be at least 1.00% higher than they are now. It could happen because Alan Greenspan finally decides to raise interest rates. Or it could happen because the fact that he hasn’t raised rates for so long will result in a burst of inflation — and when the bond market gets a whiff of that, 1.00% will only be a first stop.

In other words, you can be virtually certain that you will take that 6 3/4% loss. Or more.

And when you do, you’ll mutter to yourself the four saddest words on Wall Street: “What was I thinking?”

Well, I guess you were probably thinking that you don’t like making only half a percent on your money-market funds. And you were willing to put 6 3/4% at risk — or more! — in order to have the brief illusion that you could do better. “Stupid” is the only word better than “greedy” to describe that illusion.

So what should you do instead with that money moldering away in those half-percent money-market funds?

Simple. If you don’t like risk, just sit tight. Yields will rise sooner or later.

But if you are willing to take some risk, take some smart risk.

Risk your money on something that represents both a bargain and an opportunity — stocks. Corporate earnings have surged to all-time highs, and are still rising. With the dip in stock prices so far year-to-date, stocks have become downright cheap compared with those earnings. Especially technology stocks.

Or how about something a little less conventional — something designed specifically to take advantage of the coming train-wreck in bonds? Why not buy the Rydex Juno Fund? It’s designed to do the opposite of whatever Treasury bonds do. So when bonds drop — as I’m sure they will at some point before too long — the Juno fund will rise commensurately.

Isn’t Wall Street wonderful? So many ways to make stupid mistakes. And so many ways for smart people to take advantage of the other people who make them.

The above is an “Ahead of the Curve” column published March 26, 2004 on SmartMoney.com

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Don Luskin is Chief Investment Officer for Trend Macrolytics, an economics research and consulting service providing exclusive market-focused, real-time analysis to the institutional investment community. You can visit the weblog of his forthcoming book ‘The Conspiracy to Keep You Poor and Stupid’ at www.poorandstupid.com. He is also a contributing writer to SmartMoney.com.

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