Spain and Portugal to enact austerity measures

Spain and Portugal have each announced austerity measures aimed to reduce the size of their budget deficits.  Spain will reduce public-sector wages by 5% this year and freeze them next year, along with freezing pensions.  Portugal is cutting salaries of government ministers and other top officials by 5% and raising their value added tax by 1% to 6% for necessities, 13% for restaurants and 21% for other items.

These countries are part of the European Union countries that market concerns about their debts led to a $1 trillion European debt backup plan that was announced last weekend.  All of this was kicked off by Greece and their economic problems.

The issue is simple.  At some point lenders (those that buy your countries debt) no longer believe you have the financial strength necessary to support your debt at its present rate, and they demand much higher rates.  The 2-year notes of Greece went up as high as 18% rate of interest.  Portugal and Spain are trying to get their house in order before something similar happens to them.  The question is when will the U.S. get serious about its financial situation!?

U.S. Budget- Deficits as far as the eye can see

This week President Obama submitted to Congress his budget proposal for fiscal 2011 (ends September 30, 2011) through 2020.  Deficits for the 10 years average $853 billion (4.5% when expressed as a percentage of Gross Domestic Product- GDP).  U.S. national debt held by the public (meaning doesn't count debt held by other U.S. government agencies) as a percentage of GDP is projected to rise from 53% at the end of fiscal 2009  to 77% by 2020.  A web site has been established with all budget related information at http://www.gpoaccess.gov/usbudget/.

The ratio of debt to GDP is a big deal because those who buy our debt use this as a measure of risk in setting interest rates for such debt.  History is instructive here.  In 1960 debt was 46% of GDP, after declining from a high of 109% in 1946 from costs of financing WWII.  This decline continued to a low debt to GDP of 24% in 1974.  As recently as 2001 debt to GDP was 33%.  A rise to 77% in 2020 would make us a much bigger lending risk and would certainly drive interest rates higher.

The economic assumptions in the budget proposal reflect assumed 10-year Treasury interest rates (which are presently about 3.6%) averaging 4.5% in fiscal 2011 and then rising to a maximum of 5.3% over the balance of the time to 2020.  Actual interest rates could be much higher than these projections in a world where large budget deficits continue.  Higher interest rates would make reducing the budget deficit even more challenging.

No political leader of either party has put forth credible ideas of how to deal with this problem.  It takes political courage and the ability to voice why shared sacrifice now will protect future generations.  We can only hope some true leaders will step forward with some real solutions.  The longer we wait the harder the ultimate fix will be on everybody.

Looking back over 2009- Bonds

2009 was for bonds a year where risk paid big rewards, while the safety of places such as U.S. Treasurys (which protected so well in 2008) meant losses.  First let's look at what happened with Treasury yields-- remember that when yields go up, prices go down.  The interest rate paid on the 10-year Treasury note went from 2.25% at 12-31-08 to 3.75% currently while the interest rate on the 30-year Treasury bond went from 2.6% at 12-31-08 to 4.6% presently.  To assess the effect on investors in these instruments, consider the 21% loss for year-to-date return on the iShares 20-year Bond Fund (symbol TLT).

While rising rates hurt investors in Treasurys, the improving economy meant big gains for investors in bonds with some credit risk (meaning some risk of default).  In fact, more risk generally meant more return (just the opposite of 2008).  The iShares Investment Grade Corporate Bond (LQD) has returned about 9% year-to-date.  The Barclays High Yield Bond Fund (JNK) has earned 37% year-to-date.

Is there a lesson in all of this?  To us the dramatic change from 2008 to 2009 for bond investors simply reinforces the importance of not simply following the crowd or reacting to what all of the TV "experts" or cable talk show hosts say.  As always, successful bond investors in 2010 and beyond will be those who perform the hard work of constantly evaluating the risk/return opportunities of different bond sectors, maturities and issuers, and then have the courage to act in a manner that is at times contrary to popular opinion.

"Safe" investing in U.S. Treasurys?

When risk assets all over the world collapsed in price in 2008, many took refuge in U.S. Treasury instruments. As a result the 2008 return for the index representing various maturies of U.S. Treasurys was 13.7%. The 2008 return on the Treasury bonds with 30-year maturities was an eye-popping 41.3%.

2009 is a different story. Investors have found that investing in Treasury instruments can have a downside also as interest rates have increased and driven prices down. For the 6 months ended June 30,2009 the weighted index of all U.S. Treasury securities has gone down 4.3%. Even more dramatically, the YTD 2009 return on 30-year maturity Treasurys is a negative 20.3%.

So much for the safety of U.S. Treasurys!