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Three Bond Mutual Funds to Consider as Sequestration Begins

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As we prepare for another "continuing resolution," it's important to pay special attention to the fixed income portion of your portfolio.

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From Money Angles, by Andrew Tobias:

There was the King who held a chess tournament among the peasants and asked the winner what he wanted as his prize. The peasant, in apparent humility, asked only that a single kernel of wheat be placed for him on the first square of his chessboard, two kernels on the second, four on the third – and so forth. The King fell for it and had to import grain from Argentina for the next 700 years. Eighteen and a half trillion kernels, or enough, if each kernel is a quarter-inch long, to stretch to the sun and back 391,320 times. That was nothing more than one kernel's compounding at 100% per square for 64 squares.

When compound interest works in your favor, it is a blessing. When it works against you, it's a curse! That is a "Jeffreism" I learned the hard way back in the bear market of the early 1970s when I was working for a $100 per week in this business and consequently had my credit cards levered to the "max." The interest rate at the time was 18%. Now consider this from the same Money Angles book:

Say you borrowed $1,000 from a friend and paid it back at the rate of $100 a month for a year. What rate of interest would that be? A lot of bright people will answer 20%. After all, you borrow $1,000 and pay back $1,200, so what else could it be? FORTY percent? No, MORE! If you'd had use of the full $1,000 for a year, then $200 would, indeed, have constituted 20% interest. But you had full use of it for only the first month, at the end of which you began paying it back. By the end of the tenth month, far from having use of the $1,000, you no longer had the use of ANY money. So you were paying $200 in the last 2 months of the year for the right to have used an average of $550 for each of the first 10. That comes to a bit more than 41.25% effective rate of interest. (Trust me)."

I was reminded of Mr. Tobias' musings from 1989 as I read various newspapers over the weekend that were talking about sequestration and our nation's gross debt of $16.6 trillion (see the debt clock here). In a rising interest rate environment, with the government linking much of its debt to the short-end of the interest rate spectrum, this is not a pretty picture; and yes, Virginia, interest rates are rising. To wit, the yield on the 10-year Treasury has risen from last July's yield yelp low of 1.394% to 1.853% currently. While that may not sound like much of a rise, in percentage terms it is a 33% increase. Of course Wall Street is replete with gurus saying the Fed's zero interest rate policy (ZIRP) will be maintained until at least 2015, but I am not so sure the bond market vigilantes are not already at work. Indeed, when the cost of money (aka, interest rates) is dictated by the Federal Reserve, it is a better idea to look at the underlying measures of the funding cost. As the good folks at the GaveKal organization write:

The best proxy I know for the true cost of money is the Wicksell long run equilibrium rate, which is linked to the economy's structural growth rate. This non-manipulated measure can be calculated using the 7-year moving average of US nominal GDP growth. And when the Wicksell rate is compared to the current yield offered by BAA credits, the spread on offer shrinks to about two percentage points-a threshold, which dating back to the early 1960s, has offered a clear sell signal (see chart).

To be sure, when compound interest works in your favor, it is a blessing. When it works against you, it's a curse! Yet despite the Wicksell model's "sell signal," and my sense that the yield "lows" were made last July, it is doubtful rates are going to skyrocket in the short to intermediate term because, given the nation's debt, any severe rate ratchet would be onerous to the government's balance sheet. As Stan Druckenmiller noted on CNBC, "If you normalize interest rates to where they were before quantitative easing (QE), and use a 5.7% funding cost for this debt, that's $500 billion a year in increased interest expense. Because of this the central bank can't raise rates; it has to keep printing money."
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