As challenges to our economy continue to mount, there is a natural reaction by investors to believe that by moving their holdings into bonds and/or cash their portfolios will be "safe". A perception is held by some investors that bonds and cash are "guaranteed" and won't lose value. However, since this is a perception upon which significant decisions are being made, it is important to examine and understand the validity and strength of this perceived safety or "guarantee". A prudent investor should always evaluate underlying risks. A key point that this article will demonstrate is that there is no one investment or any one guarantee that is sufficient to provide you with true safety.
Important background: The Federal Reserve Board, the Federal Government and key influencers are working to avert a massive decline in the economy. It is in everyone's best interest to avoid one. Only time will tell whether these collective efforts will succeed or fall short. In addition, should we experience "relief", it may be short lived due to the significant amount of debt existing within our economy - the debt problem is one which will neither easily nor quickly be resolved. Plus, we must recognize that no one knows what will happen in the future or when it will occur. Investors adopting a bond-only or cash-only strategy are making a dangerous assumption that they know the direction the economy is headed. That may be a very unsafe and unwise wager. The following will address the underlying weaknesses (and danger) of bonds and cash and thus expose the "Illusion of Safety".
Bonds - these are "IOUs" issued by governments, municipalities and corporations and are based on the assumption that the issuer will repay the debt. We'll address two major types of bonds separately.
Municipal bonds ("munis") are investments that many conventional and retired investors depend on. Tax-free interest income, especially from "guaranteed" bonds with "AAA" ratings, is extremely appealing to wealthy investors. However, it is vital to understand what's behind the guarantee or AAA rating. What creates the AAA-rating for most (if not all) munis is the "insurance". When you examine the true ability of major municipal bond insurers to pay off on those guarantees, you will make some interesting discoveries:
- Munis carry a triple-A rating only because of the insurance provided by bond insurance companies like MBIA, AMBAC, FGIC or FSA.
- In almost every case the city, municipality or state behind that bond had a lower credit rating than triple-A.
- On average, these "insurers" have over 150 times as much outstanding bond value insured as they have reserves to honor those guarantees. This is an item about which Vista has advocated a concern for many years.
- If one of the largest states like California or New York were to default on its bonds, it could deplete all of the reserves insuring all remaining bonds that have been issued.
- These municipal bond insurance companies have expanded rapidly in recent years into insuring "asset-backed securities" and "structured investment vehicles" which would further threaten their ability to pay off on their guarantees under any negative scenario wherein the underlying assets lose value.
- Recent news about most of these bond insurers has revealed their precarious financial situation.
- A downgrade of the bond insurers will result in a downgrade of the munis that are insured. In fact, the day the credit rating for FSA was dropped, over 3,000 bonds which it insures were downgraded.
- Investors need to be concerned about muni downgrades as:
- Liquidity risk increases - put simply, a downgrade will result in a smaller market of interested buyers, and
- Market value declines - if risk increases and the interest payment is fixed, market value, by definition, will decline
- Two of the more well known municipal bond defaults include New York City's in 1975 and Cleveland in 1978. The Washington Public Power Supply System's default in 1982 on $2.25 billion in bonds was the largest default in the history of the municipal bond market.
- Between 1980 and 2002, there were 2,339 cases of municipal bond defaults totaling $32.8 billion-this according to a 2003 study by Fitch Ratings.
Corporate bonds don't provide tax free interest income; however, they tend to offer higher yields than munis. In fact, the highest yielding bonds (some of which are known as "junk bonds") pay a risk premium because of the weaker underlying financials of the corporation extending the promise of interest payment and return of principal. Corporate bonds do not have any form of insurance backing and should the economy face extended periods of difficulty, the ability of a corporation to "make good" on the IOU could be significantly compromised. Many years ago, bonds issued by GM or Ford were considered among the safest corporate bonds. The downturn in the auto industry exposed the reality that both of these companies may never be able to payoff these IOUs on which many investors and pensions depend. When the GM and Ford bonds were downgraded in 2005, investors faced both liquidity risk and a decline in the value of those bond holdings. Just recently, GM reported a $38 billion loss for the last year - consider how many pension funds own GM IOUs.
Cash - investors have trillions of dollars "parked" in money funds. For this article, we'll focus on Certificates of Deposits (CDs) and Money Market Funds. With respect to CDs offered by banks, it is common knowledge that deposits in the bank are insured by the FDIC (up to the typical $100,000), and most people still have complete faith in that guarantee. Now, how dependable is the guarantee of the FDIC? The real question you should be asking is, "How safe is 'safe enough' when it comes to my overall portfolio?" Obviously if you exceed the insurance limits of the FDIC coverage, you're exposed to business risks and poor management decisions on the part of the bank. The FDIC reserve level (used if a failure were to occur) represents only a tiny fraction of the deposits it insures. Many major U.S. banks are now in the spotlight as a result of poor decisions to invest in sub-prime mortgages or structured investment vehicles. These large banks, quite simply, could become insolvent, and should that occur, the FDIC will be forced to step in. FDIC reserves would be inadequate to insure these deposits. Continuing this scenario, the Federal Government, in an effort to avoid a panic, would likely "print money" to address the issue, however, this action would have a massively inflationary impact (more on this later). While that is difficult to envision, remember how hard it was to think real estate could actually decline when Vista warned of this several years ago? By way of recent example, in the mid 1980's, most markets in Texas saw a decline in residential real estate values of 15-25% when the "oil market" collapsed. Plus, the number of home sales in Texas decreased by nearly 40% during this time. Banks were deeply affected throughout the Southwest - in addition, large banks such as Chase Manhattan and Continental Illinois suffered serious losses. During 1986 alone, over 150 banks failed in Texas. A few years later, the government was bailing out the Savings & Loan industry - that effort ultimately cost an estimated $160 Billion ($124 Billion of which was paid directly by the U.S. Government.)
Money Market Funds offered by banks, brokerages and insurance companies are also susceptible to risk. The reason is that the managers of money market funds will invest the deposits in such a way as to maximize yield. There is significant competition for deposits, so fund managers will "dial up" the risk to increase the potential yield to investors. Recently, numerous money market funds managed by Bank of America, Wachovia and others have been put at risk of not being able to maintain a constant one-dollar-per-share value of the fund as a result of unwise investments in highly leveraged, structured investment vehicles. So, while investors assume that when they invest in money market funds that they will get back both principal and interest, neither of these are guaranteed. This is the reason Vista has only used U.S. Treasury Money Market Funds for years.
While you may think this level of concern goes too far or even beyond reason, the question to consider is this: Now that you know about the risk, are you willing to accept it? Have you always assumed that, should a crisis develop, the government would bail out the banks? There is little question they would try, but the magnitude of such an effort could very well have a monstrous effect on the value of the dollar and inflation. This leads us to the topic of inflation and the massive impact it can have on a bond or cash based portfolio.
Inflation - The actions being taken by the Federal Reserve Board (lowering interest rates) and the Federal Government (tax relief and stimulus packages) are intended to jump start our floundering economy. We can only hope that these actions will avert a recession (or worse), however, these actions are likely to have negative impact on the value of the U.S. Dollar. Even though the government may be able to maneuver around or avoid a meltdown, there remains significant underlying weaknesses in our economy - most notably massive debt levels that are at the highest levels in history. Inflation remains a major risk and based on the impact of current governmental actions, it will head in one of three directions:
- Moderate - this is the environment in which we have been operating over the past few decades. Overall, price and wage increases are considered to be "acceptable".
- Hyperinflation - this is "out of control" inflation where prices increase rapidly as our currency loses its value.
- Deflation - this means a decrease in the general price level over a period of time and a corresponding decrease in the supply of money.
None of us know with certainty how government actions will influence the course of inflation and which of these scenarios will unfold in the future. However, we do need to assess the consequences (risks) of holding bonds or cash in each inflationary environment as this table demonstrates:
| Inflation Scenario |
Impact on Bonds |
Impact on Cash |
| Moderate |
Highly susceptible to changes in interest rates and credit quality. Become undependable as the economy worsens. |
No opportunity for growth. Rate of inflation may outpace the after-tax yield on money funds. |
| Hyperinflation |
The "fixed income" aspect of bonds will be massively damaging in an environment where prices of goods and services are rising in an out of control pace. |
Catastrophic - value of cash rapidly deteriorates. Consumers hoard tangible goods in this environment. |
| Deflation |
While the receipt of a fixed income stream is good while the prices of goods and services decline, the ability of municipalities or corporations to make good on promises is severely compromised. |
By definition, the cash supply is significantly diminished in this environment. Holders of cash are in a good position. |
We can not choose the direction in which inflation will head but we can choose the strategy we want to take into the future - and recognize the potential outcome (consequences) of each. Making a "directional" bet (attempting to guess which inflationary scenario may unfold) is not a wise strategy because the wrong guess will be catastrophic.
As stated in the opening, there is no one investment or any one guarantee that is sufficient to provide safety, and "true safety" is that critical component that offers investors comfort and peace of mind. The wisest manner to address an unknown future is to be fully invested…in Diversification.
Diversification is the only truly safe approach to investing.
Investment
Category |
Strategic Role |
| Domestic Investments |
Markets do rise and fall. The majority of these holdings are designed for growth plus Vista maintains holdings that provide protection during declining markets. |
| Energy & Commodities |
These act as a "hedge" (protection) to offset increases in the cost of living (inflation). |
| Fixed Income (Bonds) |
Vista maintains relatively small holdings in this category as it is highly susceptible to changes in interest rates, credit quality and the inflation scenarios described earlier. Bonds become undependable as the economy worsens. |
| Foreign Bonds and Currencies |
These act as protection against the falling value of the U.S. Dollar. |
| International Equities |
These afford the opportunity to make profits while the value of the U.S. dollar is declining against foreign currencies. |
| Money Market Funds |
Vista maintains a relatively small position in U.S. Treasury money funds. While these funds are safe, they are exposed to the risk of inflation. |
| Precious Metals |
These holdings in gold and silver (largely through investments in exchange traded funds) protect against general economic panic scenarios and help to stabilize returns. |
| Real Estate Investments |
Our preferred holding in this category is mobile home parks as they perform well in both good and bad economies. |
The sequence of events that have unfolded over the past few years come as no surprise to Vista and our strategies have been designed to address these very conditions. Rather than "falling for the wrong promise" and depending on guarantees that may fail - the ONLY true safety is to "stay fully invested in diversification" as described above. Depending on "insurance and guarantees" such as bonds and cash (CDs) may very well prove to be another modern day example of history repeating itself. Analysis of long term cycles has shown that the period in which we live is characterized by massive defaults on debt of all types. At no time in history is diversification more important.
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