All That Glitters / Six Reasons to Stay Away From Government Bonds

In an environment of rising inflation and interest rates, long-term bonds are a bad idea.

On April 1, Israeli central bank interest rose to 3%, and one has to ask: is it time to get back into government bonds?

Half a year ago I wrote in this column − several times − that prices of government bonds, which are a main component of all conservative investment portfolios, provident schemes and the like, looked too high. Those were days in which real returns, after factoring in inflation, were negative. In other words, anybody who lent money to the State of Israel would get back less than he invested. One may be able to stand that in times of crisis, when people are willing to forgo returns or even pay a little to protect the value of their money. But in August 2010, it was clear that the crisis had passed its peak, that interest rates would be rising and − that anybody holding government bonds at negative returns would take a pounding.
So it was. Long-term government bonds, linked or not, have been on the decline since then. So far they’ve lost about 6%. For cautious investors, as the Arab world writhes in upheaval, the safety of government bonds may beckon: But have they finished with dropping? They may well have not. Here are some reasons why one should keep away from government bonds, for now.

1Interest rates aren’t done rising. In the bond market, the equation is simple: If interest rates are dropping, you win. If they’re rising, you lose. Economists and analysts are confident that Israeli rates are going to rise further, probably to about 4% by year’s end. Even after last week’s surprise half-percent increase to 3%, real interest rates in Israel are still negative. Inflation is running at about 4%, a situation that isn’t supposed to remain static. In the past, inflation that high always spurred interest hikes ‏(and losses to bondholders‏).

2. Inflation is raising its head in Europe as well, and calls are being heard for interest rates to rise. In the last month, European inflation has been running at 2.6%, well over forecasts. It hasn’t been that bad since October 2008. The European Central Bank governor has pledged to closely watch inflation, which is a bald hint at an impending euro-zone rate hike.

3Over in the U.S., the Fed had been saying that interest rates on the dollar would stay low for a long time. But that time is growing shorter. Top people in the U.S. Federal Reserve system are openly talking about raising interest rates, though Ben Bernanke himself hasn’t said anything. Charles Plosser , chairman of the Philadelphia Fed, put numbers to it: He thinks interest on the dollar should rise to 2.5% within a year, from its present level of roughly zero. He spoke a week ago, and all the U.S. economic data since then has supported his thesis. Consumer confidence has improved. Unemployment has dropped. Economic activity expanded by more than expected. Also, inflation is raising its head in the U.S. as well: Only the decline in housing prices continues to weigh on economic recovery.

4If European and American bonds fall, the same will happen here in Israel too. There is a direct relationaship between the price of government bonds in the U.S. and Europe to those in Israel.

5When the writing is on the wall, and it’s saying “Inflation is rising, watch out for government bonds,” you don’t want to wait. “Bonds king” Bill Gross of PIMCO has sold all the U.S. bonds that were held by the funds he runs. That is a lot of money. PIMCO runs $1.2 trillion in managed assets, almost all of which had been in bonds. Gross’s move is a career maker, or breaker: If he got it wrong, his career will be dead in the water.

6What about that other legendary investor, Warren Buffett? He specializes in corporate bonds, not government ones, but he also has $40 billion cash that needs management. During his visit to India two weeks ago, the oracle of Omaha put it this way: He advises against investment in long-term dollar-denominated bonds. He thinks the dollar will be worth less in four or five years. He prefers investment in real companies.
What to do? In an environment of rising inflation and interest rates, long-term bonds are a bad idea, especially government long-term bonds. What is a good idea, then? The bold are fleeing from bonds to stocks, despite the risks lurking there. The conservative will stash their cash in bank deposits or short-term bonds such as makams. With interest of nearly 3.5%, makams have become a decent parking place for cash, for a year, until the global economy decides where it’s going, or until interest rates stop rising. As Buffett likes to say, “Rule No.1: Never lose money. Rule No.2: Never forget rule No.1.”