The Aftershock Investor: A Crash Course in Staying Afloat in a Sinking Economy (21 page)

Given these three very nice safety features, investors tend to think of many bonds as nearly risk free. However, nothing could be further from the truth in a falling bubble economy in which the government is massively printing money. As we will explain in more detail shortly, as inflation goes up and interest rates rise, bond values will quickly fall. While there is a bit of concern that interest rates cannot stay this low forever, in general, investors are not too concerned about rising interest rates or a big downturn for bonds. This is the key reason that so many individual and institutional investors who follow conventional wisdom on bonds will get hurt so badly in the coming Aftershock:
They aren’t expecting it
. Any investor who is younger than 50 years old has been in a bull bond market their entire adult life. That’s a large percentage of our investing community, and they will be very much taken by surprise. When inflation and interest rates rise significantly, long-term bonds—and
all bonds
—are going to take a terrible beating. Many large institutions are heavily invested in bonds, especially long-term bonds, and a significant chunk of their assets will go to Money Heaven.

Almost all conventional wisdom–type thinking usually has a good historical basis. So to understand CW we need to look at recent history. Only by understanding CW can we understand the Aftershock view on bonds and why CW is wrong.

Like stocks, we don’t need to go back to the beginning of the bond market; we just need to take a brief look at the more recent history of bonds because that’s what CW focuses on. So, if we look back at the beginning of the modern bond market in the late 1800s and early 1900s, we see that bonds dominated the investment landscape. Stocks were not very important. As we discussed in the previous chapter, they were considered too risky, even for institutional pension funds. Eventually, as we moved into the 1960s, stocks became more acceptable, but bonds maintained their position as a much less risky and more stable alternative to stocks. Bonds were the way to reduce risk in a stock portfolio.

However, by the beginning of the 1980s, bonds had entered a new era. Three major changes were about to occur:

The first factor, declining interest rates, made bonds a particularly good investment. Remember what we said earlier about the importance of looking at the total return of the bond, not just the interest rate. As interest rates fell, bonds were showing excellent capital gains. As you can see from
Figure 5.1
, this bond bull due to falling interest rates has continued to this day and will likely continue for a while longer in the future.

Figure 5.1
Falling Interest Rates Have Pumped Up Bond Prices Since 1980

Bonds have been a very good investment since 1980.

Source
: Bloomberg and Bain Capital.

Of course, that’s where the second big change in the 1980s gets more important. Since the 1980s, the amount of outstanding debt has exploded, as
Figure 5.2
indicates. This is not just government debt but all debt, including corporate, mortgage, and consumer debt. When the bubble economy pops, this massive debt will be absolutely explosive. We saw a preview on a small scale of what’s to come with the mortgage debt–fueled financial meltdown in 2008.

Figure 5.2
Bond Market Growth, 1990–2010

The size of the bond market has exploded since 1980.

The mortgage meltdown was only a small preview because mortgage debt is only a small part of the world’s overall debt. Also, the U.S. government, through its massive borrowing and money-printing powers, was able to step in and essentially take over much of the mortgage debt market. In Europe the same thing is happening, with a combination of increased borrowing and some money printing being used to stabilize the government debt situation for Greece, Spain, and Italy.

Many people think that because the government was able to take over the mortgage market, and governments in Europe have been able to keep the European debt situation from melting down, at least so far, that there isn’t a much larger debt problem. But the massive debt problem is still there; it just can’t be as easily seen. And if it can’t be easily seen, you can bet that CW won’t see it. The last thing CW wants to spot is problems.

What can be easily seen is that bonds have performed very well over the past few decades, and even before then they were certainly quite safe. Yes, there were some problems in 2008, but they were solved. Hence, bonds still seem safe and their investment performance has been amazing. So, needless to say, CW is very happy with bonds. History proves they are right. Right?

But what if the underlying conditions of the past change in the future? What if that massive increase in debt is actually undermining the ability of governments and people to pay off these bonds? Most importantly, what if the world’s bubble economy pops and inflation and interest rates rise substantially?

With those questions in mind, let’s look at the Aftershock view of what will happen to the bond market in the future. Needless to say, it isn’t what CW sees now—or ever wants to see.

Conventional wisdom on investing in bonds is wrong because it relies on two key assumptions that, unfortunately, are dead wrong:

Let’s tackle each of these wrong assumptions one at a time.

First of all, and most importantly, the future is not the past! It never was and it never will be.
Markets always evolve
. There is never a question of
if
a market will evolve; it is always only a question of
when
. The bond market has enjoyed an amazing run, beginning in the 1980s. As great as it has been, what justification or evidence do we have right now to believe that somehow that great run will never end? Right now, interest rates are ridiculously low. Is it reasonable from here to expect interest rates to fall even lower? Logic tells us that interest rates are far more likely to eventually rise than to fall even further.

You don’t have to buy our macroeconomic point of view to see this eventually happening. As a general rule, interest rates tend to run about 2 to 3 percent above the inflation rate. That is certainly not the case today. Interest rates are very low, relative to inflation, and some interest rates have actually gone so low that they are now in negative territory. For example, as of this writing in June 2012, the Swiss two-year bond had a coupon of −0.5 percent. That means investors who buy this bond are not only willing to make no profit on the bond, they are also willing to lose money, just for the safety of “parking” capital in what they view as a safe haven.

With current interest rates so atypically low and even negative, the odds are that interest rates will eventually rise, or not fall much further, in the future. Right now, massive money printing is keeping interest rates low, but massive money printing cannot go on forever.

Why can’t money printing go on forever? At the risk of driving you crazy from repeating ourselves in every chapter, it is because
massive money printing eventually causes massive inflation
. You simply cannot print money without end and avoid devaluing the dollar. If we could escape that basic truth, we could just keep printing without end and forget all our money problems forever. Can’t do that.

Expanding the monetary base will cause rising inflation (for details, please see Chapter 3 and also see
Aftershock
, Second Edition), and rising inflation will cause rising high interest rates. Remember, you don’t need too much of an increase in interest rates to get a
big drop in bonds
. Even a small increase pushes bond values down (see sidebar and
Table 5.1
). Therefore, a big rise in future inflation and interest rates will create a massive downside for bonds.

Table 5.1
Interest Rates Up, Bond Values Down

This will be true, right up until the minute it is no longer true. Certainly, the federal government will do all it can to protect bondholders, if for no other reason than as soon as it stops protecting bondholders, it can no longer issue any more bonds because no investors will be willing to buy those bonds.

But as we approach the coming Aftershock, the government will not be able to save the bond market. Why? Because . . .

The dollar bubble and the government debt bubble will be the last of our six conjoined bubbles to burst. The first four (stocks, real estate, private debt, and discretionary spending) bubbles have already begun to fall, and they will all fully pop when the last two finally go.

To support the falling economy since the real estate bubble popped and the stock market crashed in late 2008, the government has been employing two powerful types of temporary stimuli: huge deficit spending (borrowing money) and massive money printing (which makes that huge borrowing possible by keeping interest rates low). This has worked in the short term. Without these types of stimulus, the stock market and economy would have crashed by now.

However, as we have pointed out again and again, the stimulus itself will soon add to, not cure, the problem. That’s because huge deficit spending, while a temporary boost to the economy, adds to our already huge government debt bubble; and massive money printing, while a temporary boost to the stock market, will create rising future inflation (eventually popping the dollar bubble). And when inflation rises significantly, interest rates will rise. Also, the value of the dollar will fall—and so will the value of most dollar-denominated assets, as investors make a mad dash to get out of them.

Rising inflation and rising interest rates would be bad for any economy, but they are especially bad for a multibubble economy already in decline. High interest rates will be bad for stocks, bonds, real estate, and businesses. And high interest rates will be especially bad for the government debt bubble. That’s because the government never actually pays back the principal of its debt, only the interest payments, and it makes these interest-only payments by borrowing more money. Therefore, each time interest rates rise, the government has to borrow again and again at the new, higher interest rate, adding exponentially to the debt.