I’m turning my attention to finance and investment this time around to talk about the decimation of yields, the interest rates paid to bondholders for the privilege of buying bonds. Yields are at the lowest level in over 50 years. This is bad news for bondholders, mainly retirees, that rely on the interest payments for income. What has caused the death of yield? One simple answer: the Federal Reserve.
Fed Funds Rate
Interest rates are set by the market, as is everything else. Since the advent of the Federal Reserve, interest rates are no longer set by the market, they are targeted and manipulated by the Fed through the Federal Funds Rate. This is the rate member banks pay each other for overnight inter-bank reserve loans. The Fed doesn’t directly set the rate, it sets a target rate. This rate is achieved by the Fed buying or selling Treasury bonds based on banks are charging each other higher or lower than the targeted rate.
Credit Bubble
What does the fed funds rate have to do with declining yields? The Fed will lower the fed funds rate target when it wants to juice up the economy. In other words, they want banks to lend money, and lots of it! Former Fed chairman Alan Greenspan did this recently back in 2001, dropping the rate down to 1%. This directly caused the housing bubble and we are living through the bust now. This artificially low rate caused mortgage rates to plummet and opened up the flood gates to new mortgages, refinances, subprime loans, no-doc loans and everything else.
When the fed funds rate is low, it means credit is available cheaply and in near abundance. There is an over-supply of credit. Interest rates for treasury bonds, credit cards, corporate bonds, state and municipal bonds will fall according to the fed funds rate. This is why Treasury bonds are paying a pittance. For example, a 2-year Treasury note is paying 0.57% interest. Yes, that’s 1/2 of 1 percent. A 10-year is paying 2.79% and the 30year is paying 3.87%. Think about this, you loan the government your money for 30 years and they will pay you 3.87% interest. That is insane!
Fixed Income Decimation
The Federal Reserve favors debtors over savers. The entire banking system is built on easy credit to make loans and increase the money supply. Savers get the short end of the stick with artificially low interest rates. If you have a basic savings account, you know how non-existent the interest rate is. If you’re lucky, the yield it’s just over 1%. For bondholders receiving income from the yield, it can be devastating when it’s time to roll over the bond. By rolling over, the old bond’s principal is paid back and rolled over into a new one, at a lower rate! Say you bought a 30-year Treasury bond back in 1980. The average yield is ~12%. For the next 30 years the Treasury would pay you 12% interest on the $1000 you loaned them. Now, in 2010, that bond has matured and you need to roll it over into a new 30-year bond. The $1000 is paid back and you buy a new 30-year bond. The interest rate now? just under 4%. Do the math. That’s a big pay cut.
Any Solution?
Is there anything fixed-income people can do to increase yields? As long as the Fed continues to target the fed funds rate at 0.25%–and there’s no intention for them to increase it any time soon–there is little one can do without increasing the risk of losing the principal. Junk bonds always pay a higher rate as do emerging market debt. But, one of the factors of determining the yield is the debtors ability to pay the rate. Greek bonds may be yielding 7-8% but is it worth the risk of default based on their recent past?
Stock Dividends
Jim Pulplava’s Financial Sense podcast had a segment this week on stock dividend yields. The low interest rate environment has created something that hasn’t been seen in a very long time. We are seeing stock dividend yields higher than bond yields. While there are fewer companies paying dividends than ever before, many blue chip companies continue to pay dividends, and they have been increasing their dividends every year. These dividends are higher than Treasury yields, and in some cases, higher than the company’s own bond yields! I’m looking into moving some investment dollars into blue-chips with high dividend yields, but the majority of my portfolio is still sitting tight with gold and silver.
Conclusion
The Fed has really screwed the pooch this time. In a sense, it’s not surprising as the Fed has been doing this since its inception. We’re just seeing the extremes of its monetary policy delusion. In the end, it decimates us all.
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