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The Bubble is in Bonds - Not Stocks

June 23, 2013
Leverage Can Kill

America’s national debt exceeded $15 trillion [with a T] for the first time on November 15, 2011. Deficit spending since then has pushed the total national debt closer to $17 trillion.

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An official population of 316,110,225 means every man, woman and child in America now owes $52,953 plus future interest costs. It should be noted that this does not include enormous unfunded liabilities for Social Security, Medicaid/Medicare or the potentially crippling burdens of ObamaCare.

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Incremental debt is being added at an unprecedented rate. The Treasury bond auction market tells us nothing about the true state of interest rates as shill bids from the Fed have sucked up virtually all net government bond issuance this year.

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Europe is already in recession and drowning in debt. There are no solutions on the horizon. The idea that the Fed will cut back on money printing/bond buying programs is pure fantasy. The politically expedient solution still suggests QE continuation or even expansion, both here and abroad. The only alternative is the outright confiscation of wealth. That technique was beta-tested just months ago in Cyprus.

Pundits are screaming about the risk they see in the equity markets. In reality, stocks are not overpriced. Bubble valuations currently reside in the fixed income arena.

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At some point a new credit crunch or even a freeze is brewing that could be worse than we saw in 2008. There is no way to know when that will happen but you should be preparing yourself for that eventuality.

Holders of long-term bonds are taking huge risks. A 1% rise at the long end of the yield curve could send 30-year bond prices down 17%. A 2% increase could drop principal values much more that. Years of coupon payments could be wiped out on a total return basis.

Long maturity corporate paper issued just weeks ago as part of Apple’s (AAPL) $15 billion debt offering have already been marked down by over 10%. Avoid all bonds if possible. If you must keep any fixed income vehicles be sure they have short maturities.

2008 taught us that highly leveraged companies, or healthier ones with even moderate levels of maturing debt, can be forced to issue dilutive shares or descend into bankruptcy quick rapidly. Make sure any stocks you own have enough predictable cash flow to service all bond interest as well as principal payments coming due within the next couple of years.

In extreme conditions even top-rated firms can be forced into coercive terms if they need to refi when money is tight. Remember how Berkshire Hathaway extracted 10% interest plus warrants from Goldman Sachs, GE and others during 2008. The next cycle could see even more punitive terms.

You can check the balance sheet data by consulting subscription services like Value Line, S&P or Morningstar. Free sites like Yahoo Finance and MSN MoneyCentral also offer access to up to date information on this very critical metric. A firm that cannot meet its bond obligations is at the mercy of their lenders.

Ensure that your own portfolio is now unlevered. Debt-free portfolios can wait out any temporary storms or even jump in after a major sell-off.

Bonds appear riskier than stocks. Shares of highly levered companies have benefited from artificially low rates by refinancing old debt. They have also borrowed to pay for massive share buyback programs. Those times may be coming to an end.

Stick with shares of dominant companies with rock solid balance sheets.


To see details on my Value Portfolio click here http://marketshadows.com/virtual-portfolio/

About the author:

Dr. Paul Price
http://www.RealMoneyPro.com
http://www.MarketShadows.com
http://www.TalkMarkets.com

Visit Dr. Paul Price's Website


Rating: 3.7/5 (15 votes)

Comments

AlbertaSunwapta
AlbertaSunwapta - 9 months ago
;-)

Just to be flippant, it seems you're making some macro market forecasts. Hussman would be proud of you.

Anyway, you say that stocks are not overpriced and that may be so however assessing that statement depends on a number of factors beyond my ability. I believe many quality companies are fairly valued if not cheap considering the potential range of future alternatives.

What worries me is the transition to those alternatives. What is a reasonable discount rate, earnings growth assumption, etc for the overall market? When or if a major subsidy is withdrawn what will be the reaction and the unintended consequences? And will any flight to quality include quality companies or will behaviour mimic the 2008/09 crisis, or there be no flight of capital anywhere?

Please leave your comment:


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