- Rich or Poor, You Can’t Ignore U.S. Treasuries in Today’s Markets
- Fiscal Cliff 2013: How Investors Can Prepare
- Why to Buy Dividend Stocks Now
- Five Savvy Ways to Conquer the Wall of Worry
- The Hunt for Higher Yield: Investors Pour into Emerging Market Debt
- The Debt-Ceiling Debate: The Death of the "Risk-Free" Investment
- How to Profit From the "Widow-Maker" Trade – Shorting U.S. Treasury Bonds
The fiscal cliff is a real crisis looming at year's end. The fragile U.S. economy could face an unparalleled fiscal punch of as much as $720 billion if the scheduled changes go through as planned. They include the Bush-era tax cuts set to expire Dec. 31 and billions of dollars in programmed federal spending cuts.
U.S. Federal Reserve Chairman Ben Bernanke has warned that shocks from such changes will most likely cause the economy to contract, causing a recession.
And without cooperation from Congress, there's no alternate route for the U.S. economy to take.
Ernie Gross, Ph.D., MacAllister Chair and professor of economics at Creighton University, told Forbes, "The fiscal cliff is an almost 100% certainty."
Before the financial crisis, prudent investors counted on CDs, U.S. Treasuries and savings accounts to provide them with decent interest income for their retirement.
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But thanks to Federal Reserve Chairman Ben Bernanke's zero interest rate policy, prudence has become a tough way to fund your golden years.
With few places to find refuge and income, these cautious investors have been forced to look elsewhere-namely at dividend stocks.
Dividends, long used to pad portfolios with income, are no longer a risk-on or a boring way to invest.
Not only do dividends add value, but with a careful selection across several sectors, an investor can build a nice portfolio covering a broad range of industries.
What's more, dividend-paying stocks provide reliable returns at regular intervals, offer growth potential, and are not typically as economically sensitive as other high-beta and volatile companies.
Another bonus is that when the economy wanes and stock markets fall, dividend stocks pay investors to wait it out until things improve.
And since cash dividends are paid from a corporation's current earnings and profits, dividend investors have the added prospect that they may see their dividend payments raised as things improve.
That's why dividend stocks have been a long-term bright spot with investors clamoring for higher yields.
Nick Lawson, head of synthetics, macro and cross-selling for Deutsche Bank, told the Financial Times, "We've had a lot of people from fixed income coming into equities. I think it is straight yield. We have all been forced up the yield curve."
If you like extreme risk and consider living on the edge to be "normal," today's column isn't for you.
Today I'm writing to the millions of investors who are completely terrified by the prospect of what's next and who simply want their faith restored - not to mention their investments.
To all of them I would say: You are not alone and you're not wrong to be apprehensive.
Our political situation is an embarrassing train wreck, our national debt looks like a one way trip to financial hell, housing remains in the dungeon, unemployment is unacceptably high and Europe...oh Europe.
It's nothing short of a gigantic wall of worry.
Plus, there have been so many attempts to "fix" things that I've lost count. Throwing good money after bad is a fool's game and one that will have very real and inevitable consequences.
So what should investors do?
The Fed's War on CapitalismHere's how I see things. The "Whitewash Ministry" has basically five options:
Even though both would be the proper way for free markets to bleed out the excesses of the past, they are essentially political nukes and nobody has the willpower to touch either one of them.
The third, austerity, is being tried but only halfheartedly. Our leaders have no idea what this actually means. Since they remain completely unaccountable, there is no true incentive.
Besides, large numbers of people have figured out it's easier to be on the dole than it is to actually work, so this is another disincentive for meaningful cuts in spending.
As for inflation, this too is officially a non-starter as long as interest rates are held near zero. Unofficially, it's a different story. Most investors I know are feeling the heat of 12% to 15% a year in their wallets.
That leaves option number one - repression.
You can call it what you want, but repression is really a fancy way of saying that our government is conducting punitive monetary policy.
While they mouth off about how they want to create jobs and take care of the middle class, in reality they're eviscerating it.
The never-ending hunt for higher yield is leading investors to bet record amounts on emerging market debt.
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In just the first two weeks of 2012, governments of undeveloped economies from Asia to Africa sold more than $30.6 billion in dollar-denominated bonds according to Bloomberg News.
That's up from roughly $19.9 billion in the same period last year and the most since 1999, when Bloomberg began collecting data.
Typically, investors shun emerging market bonds during times of uncertainty in favor of "safer" assets like gold and U.S. Treasuries.
But that has started to change.
The Big Move Into Emerging Market DebtIn fact, investor demand is overwhelming supplies as orders have outstripped the amount of bonds being sold.
During a recent auction, the Philippines received $12.5 billion of orders for $1.5 billion of 25-year bonds, pushing the yield down to a record-low 5%. Indonesia sold 30-year bonds at a record-low yield of 5.375% and Colombia sold $1.5 billion of 29-year bonds at 4.964%.
Analysts say the debt crisis in Europe, along with record low yields on U.S Treasuries, has investors on the hunt.
They are now buying the debt of undeveloped nations like Indonesia, Mexico and Brazil, even though credit-rating firms rank them as more risky than their European counterparts
"What we're seeing is a re-evaluation of sovereign-credit risk, increasingly being driven more by fundamentals than by classifications," Eric Stein, a portfolio manager at Eaton Vance Corp. (NYSE: EV) told The Wall Street Journal.
According to the J.P. Morgan Emerging Markets Bond Index, investment-grade sovereign emerging-market bonds are yielding an average of 4.7%.
By contrast, Italian 30-year debt yields 7%, while Spanish 30-year debt yields 6.1%.
One reason emerging market bonds are attracting interest is...
And whether or not the United States defaults on its debt when the federal government hits its debt ceiling on Tuesday, the threat by Standard & Poor's to downgrade the United States' top-tier AAA credit rating means there will also be no such thing as a "risk-free" investment.
This new financial reality will alter the global-investing landscape forever.
And though it will put a hurting on hedge funds, investment banks and the rest of Wall Street, the death of the risk-free investment may prove beneficial to those of us who are America's ordinary retail investors.
Let me explain ...
Modern Portfolio TomfooleryA central assumption of modern financial theory (also known as "modern portfolio theory," or MPT) is about to collapse: From Aug. 2 forward, there will no longer be such a thing as a "risk-free" investment. Banks and hedge funds will be turned upside down, but even those of us who regard modern portfolio theory as mostly rubbish will discover that the financial markets have started to function in very different ways.
Modern financial theory was originally developed at Carnegie-Mellon and the University of Chicago in the 1950s, and since then has become a dominant element of every Wall Street operation (helping Wall Streeters make boatloads of money, as a result).
One of the core precepts is that there are such things as "risk-free" investments, in which an investor's principal is 100% safe - not 99.5% safe, but 100%.
For example the Capital Asset Pricing Mode (CAPM), a central theorem of modern financial theory, says there is a "frontier" of optimal investments, and that investors can achieve any mix of risk and return on that frontier by combining risky and risk-free investments (or, to increase risk, leveraging themselves).
Similarly, the Sharpe Ratio, used by professional investors in hedge funds and pension funds, evaluates securities and portfolios by the "excess return" generated over a risk-free investment. That helps money managers determine whether they are paid sufficiently for their risk. In options theory, the Black-Scholes model assumes the ability to "delta hedge" an option by buying or selling the underlying security, and borrowing or investing the proceeds at the same risk-free rate.
Finally, risk-management theory assumes the possibility of eliminating risk from portions of the portfolio, so that the Basel bank regulatory systems, for example, weight Treasury securities of Organisation for Economic Co-operation and Development (OECD) governments at zero. That allows banks to hold unlimited quantities of Treasuries, without having to allocate capital to those holdings.
The Death of the "Risk-Free" InvestmentIf U.S. Treasuries are not AAA-rated, then they are not risk-free - pure and simple.
Doing so right now is nothing more than a "widow-maker" trade that will test both your patience and your pocket book. And yet, "shorting" the U.S. Treasury bond market is an opportunity you can't afford to pass up - so long as you execute the trade correctly.
For the best Treasury bond strategy to deploy right now, please read on...