Bonds, Bond Funds, QE2 and the Mortgage Mess, and the Tax Cuts

Of bonds and bond funds

A few years ago I took a workshop on investing led by a local Merrill Lynch representative. (Yes from the very same office that Suze Orman and I both worked at long ago!) His workshop covered bonds, and he pointed out the disadvantages of owning bond funds.

Afterwards, feeling worried, I went up and asked him about my Charles Schwab short-term-yield bond fund. Basically he said that fund was a bad deal, and I should get out. Sadly I decided not to trust him and stayed in.

As a novice to bonds, I thought that higher yields were a good thing. To me they seemed just like high yields on stocks. “Up” is good when it comes to interest income, right?

Well, no, bonds are not stocks. Stocks are a piece of the pie. When stock prices go up it means the pie just got bigger, or at least people think that pie looks bigger.

Bonds, on the other hand, are debt. The company or government entity is not selling pieces of itself to you; it’s borrowing your money and is supposed to pay you back. The bonds the company or government entities sell are actually IOU’s.

When yields on IOUs go up, it means they’ve become hot potatoes. People fear they won’t be repaid. Or they may fear that the IOU’s face value won’t be worth much after inflation takes out a big bite.

When interest rates on bonds go up, more people are trying to sell their bonds on the one hand, while on the other hand, fewer and fewer people are buying those bonds, no matter how low their price goes.

And that was the rub. Not wanting to sell as the price on my bond fund went sliding downwards, I held on until I’d lost so much of my initial investment in the fund, I finally knew I had to bail. And good thing I did! After I bailed out, the price of that fund kept right on going down right until Schwab was sued over it.

No surprise then that “Investors Pull Cash Out of Bond Funds” is the headline in the Wall Street Journal today.

QE2 and the mortgage mess

So how is the government’s plan to buy back its own bonds working? Well, I’m sure you know the answer. QE2 is doing the opposite of what was hoped. Yields on government bonds aren’t going down. They’re going up.

You know what that means. Bonds are hot potatoes now; their prices are plunging as more sellers than buyers enter the bond market. While investing in stocks is going up, the government’s dream of increasing consumer spending through lower bond yields is fast receding.

Bank interest rates for mortgages (and other consumer loans) are directly tied to the yields paid on 10-year government bonds. A piece called “Federal offensive” in the Financial Times Lex Column offers well-told tale explaining the impact of QE2 on the mortgage mess.

“The story starts like this:  the Federal Reserve sees the housing market still in a slump and thinking fiscal stimulus ruled out, it decides to buy even more bonds. Benchmark mortgage rates drop to an all-time low of 3.21 per cent.

But then voters speak, and punish free-spending Democrats. The result though, is the newly chastened president makes a deal on taxes and benefits with resurgent Republican politicians that adds another $900 billion or so to the deficit. [And that brings on fears of default by the government and inflation]

The outcome:  a fearful market pushes up yields, bringing mortgage rates back up by almost a third in barely a month, to 4.16 per cent. A weak housing market could get weaker.”

Another story in the news today tells of fearful homeowners trying to get above water by paying down mortgage debt faster than ever before. And another article recently spoke of the moribund state of the MBS (mortgage-backed securities) market right now.

For sure, near-total stagnation in the mortgage market is not creating wealth or jobs! Banks are stepping up foreclosures and tightening loan requirements. They are barely loaning at all, let alone at the lower rates the government hoped for.

So how about those tax-cut extensions?

Republicans fought long and hard for the extension of the $900 billion Bush tax cuts. They went so far as to threaten to block all bills until the end of this term of Congress if they did not get extensions of tax cuts for the wealthy. To get these breaks they even abandoned their opposition to the extension of unemployment benefits to 2012. The Financial Times says that for Congress, US tax cut extension seen as trigger for growth.

Their reasoning is that wealthy people spend their money on investments in companies and that makes the economy grow. Clearly those investments are not likely to be in bonds right now. So we can expect the stock market to be a primary recipient of tax savings of the wealthy. But will that help? Yes, but not most of us.

First of all, investments in emerging countries are booming because their stocks are paying higher yields and some investors deem them “safer” than stocks of developed countries right now. These kinds of investment don’t translate into jobs or growth in the US, except perhaps from an increase in the number of buyers of US exports abroad.

Cheap US exports is one reason that large American companies with multinational operations are doing much better than the American companies who sell mostly in the US. However, as mentioned in my “Quantitative Easing – What Will It Do?” these companies are hoarding about a trillion dollars

About, $400 billion of that trillion is being kept abroad because American multinationals want bigger corporate tax breaks on foreign income. Unless that happens, sales they make abroad will creating wealth and jobs abroad, not here.

In general, most large companies in the US are clinging to cash use of surplus inventories. “Coffers swell to 51-7ear high” says one article. None of these companies are  likely to invest that cash to expand until they are surer that the economy will start moving forward again.

So why should anyone believe that the Bush tax cuts for the wealthy will create any more jobs now than they have in the past few years?

Because they could do the trick…but only if the wealthy are also wise. There won’t be many jobs or more personal consumption in the US if the money from QE2 and tax cut extensions will all be going abroad.

So, if you happen to be a lucky taxpayer with disposable income, especially one of those wealthy 1 to 2% of American taxpayers at the top, please support small businesses and buy American-made goods from companies who sell mostly in the US.

While Obama pushes CEO’s to get them to spend their trillion of excess cash to put some of our ten percent of unemployed workers back to work and banks continue to respond to pressure to take responsibility for the bad mortgage loans they made, this is your chance! It’s all up to you now. Be a real angel on earth this year. Do what our government, companies and banks clearly can’t. Give us a real stimulus!

Copyright © 2010 Nancy K. Humphreys

1 comment so far ↓

#1 Mary on 12.20.10 at 1:47 pm

Interesting piece. Once again I learned a bunch, but I have to say I don’t think your plea to the wealthy will do any good. So I don’t think it is a great idea to give them a tax break while stiffing the middle class once again.

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