We have been sending a warning out to all of you about bond's and bond mutual funds. Obviously no one is paying attention at least according to the latest statistics from the Investment Company Institute. Their latest report on mutual fund flows for the week ending May 20, 2008 indicated that $8.4 Billion of new investments were made in Bond Mutual Funds, while only $252 million was invested in Domestic Stock Mutual Funds. I don't get it!
Bonds incorporate two primary levels of risk; interest rate risk and default risk. Default risk is easy to understand, especially with the recent bankruptcy of General Motors. The $27 Billion of GM bonds held mostly by individual investors has been completely lost - so much for the safety of corporate bonds. But the bigger risk going forward will be an interest rate risk.
Most people understand that the current value of a bond is based on the interest rate paid and the return of principal at some future date. If interest rates increase, the current market value of a bond declines. Unlike an individual bond that can be held until maturity for the repayment of your principal, bond mutual funds do not offer that same option. This lets us know that changes in interest rates will have a much greater impact on the current value of a bond mutual fund than credit risk.
Interest rates can be considered to be the cost of borrowing, and in our economy, they are set for the most part by supply and demand. If the supply of bonds available to the public increases, then the price (interest rate paid) will need to increase to the point that the demand equals the supply. The biggest borrower is the US Government, and this is our concern.
As most of you know, when tax receipts do not meet our spending needs, a deficit occurs and this deficit is funded with new dollars borrowed by issuing new bonds. In July of 2008, the Bush administration estimated a $482 Billion deficit. In January 2009, this estimated deficit was increased under President Obama's administration to $1.2 Trillion. But given the anemic tax collections since the first of the year this estimated deficit has been increased to $1.8 Trillion.
However, I question, is that enough? Tax revenues have decreased year over year by an estimated 40%. A lot of you believe that this will be corrected by tax increases on the rich. Don't kid yourself! According to the IRS the top 5% of US Taxpayers pay 60% of all income taxes collected. Maybe I am being a bit naive, but I truly believe that these 5% are doing everything in their power to reduce the amount of income taxes they pay. Not only that, but they have been taking steps to reduce their payments ever since the new administration pledged to have them pay for the deficits. Do you remember - "No new taxes for 95% of Americans"?
Unless things change greatly, the deficit will increase, as will interest rates. Don't get caught holding the bag.
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