August 26th, 2013 11:34 AM by Nick Rapplean
In 1981, I handled the sale of my grandfather's home on Lido Isle in Newport Beach. He was utterly thrilled to receive $180,000 for the property, which he considered an incredible example of luck, given that it didn’t fit into his view of reality that real estate could ever be a genuinely profitable and reliable investment. His plan, therefore, was to buy up as many 30-year Treasury bonds as possible with the proceeds from his home sale and to move with his beloved wife into a retirement apartment.
At the moment, 30-year T-bonds bore a yield of about 15.25%. Grandfather thought he was getting away with murder, so to speak. His sense of economic reality didn't include bonds with such huge yields. And the thought that you might purchase them with the proceeds of a real estate sale simply didn't compute in his worldview at all. He rushed into the bond market with his proceeds and bought up bonds as if racing against the time when some unforeseeable reality erased the opportunity.
Grandfather was blinded to many viable investment opportunities by his belief system. He ended up making his choices with a very defensive quality, making sure he wasn't burned by the strangeness of sizzling high bond yields, and a faltering stock market.
Notice, though, that the 30-year T-bonds yield then took a long downward walk to about 2.5% in June, 2012. As long as the yield was declining, the bonds my grandfather had bought became more and more valuable. (He ignored what was happening to the market value of personal residences on Lido Isle after he sold, very nearly incapable of even seeing what was going on.)
Along with the bonds increased value, a 15.25% 30-year bond gaining greatly in value when the price of a newly-issued 30-year bond declined to, say, 12%--there was another crucial process underway. The adjustable rate mortgage, which had a built-in mechanism that elevated its mortgage rate and monthly payment rates when bonds and other instruments used as indexes happened to rise, displayed its ability to benefit borrowers by doing the reverse, lowering its mortgage and payment rates when the relevant index interest rate declined.
As a consequence, it required some creativity to avoid coming out ahead over time with the new ARMs. I remember an ARM in the early 1980s whose rate and payment adjusted to the 1-month LIBOR with a 1% added spread. Imagine the good fortune of the homeowner who took out such a loan and held on to it for its full life. The rate and the monthly payment fell, step-by-step, to levels most of us never expected to see again.
All of which shines a light on two very important points. First point: Different strategies work at different times. Now is almost certainly not the time to take out an ARM we plan to hold to maturity. As PIMCO's Bill Gross has been warning us for many months, we are in the midst of a major change of direction for interest rates.
They are about as low as they are likely to go at this point, and may be likely to rise for a long time, making their way, perhaps, back into the 10% to 15% range. But this brings up the second point: Most borrowers and investors tend to be stuck in the last market phase.
Thus, in this case, they tend to assume that a phase that brought rates down from 15+% to 2+% will be replaced by a phase, only now arriving, that will take them back up. It isn't a reliable assumption, I suspect. In fact, we seem to have reached a point when all recognizable bets are off. One possibility, for example, is that interest rates will rise very gradually for several years, moving with a gradual firming of the economy. But that could prove wrong, too.
What is likely to prove wrong is the idea that rates may fall significantly further in the near- to mid-term. Yet a great many of the worlds investors are terrified that even slightly higher rates will land on this economy like a meteor. Doubtful.
But we remain with a Federal Reserve that is trying to keep everything pretty much as it is right now, not tapering its QE3 program until, say, mid-2015, as if today's economic growth were being driven by QE3 rather than the reverse. My tentative view of all this is that we may be failing to inspire and support a stronger, self-sustaining recovery. The good news, though, is that the economy continues to grow in harmony with higher rates. If that continues, there is probably still money to be made.