Tags: Riskless | Assets | Dangerous

When Riskless Assets Are Most Dangerous Game in Town

By    |   Tuesday, 10 Jan 2012 08:51 AM

Something odd happened in Germany on Monday.

The country sold more than $4 billion in six-month bonds at a yield of negative -0.0122 percent. It’s the first time that investors have bought German bonds at a negative yield, although it’s happened a few times in the United States.

What does a negative yield on bonds mean?

For one, it means that investors are literally paying Germany a small sum for the privilege of lending them money.

This absurd development shows us two things.

First, bonds are in a bubble. Yes, interest rates are near historic lows and will likely remain so for a few more years to come. Because the yield of a bond goes down as the price goes up, a negative yield implies that the price has lost track of reality.

Second, investors in Europe are still fearful. They’re so afraid of potential losses in other assets right now that they’re willing to take a small (but known) loss by investing in bonds. Investors typically have an incentive to invest in bonds because they earn a modest, but low-risk return. That’s in contrast to a potentially large (but unknown) loss by investing in European stocks.

Treasury bonds soared 9.8 percent last year. That return not only beat the stock market by a wide margin, but it’s also a huge move for an asset seen as risk-free. So either it’s not really risk free (and may indeed be in a bubble), or Treasury bonds were substantially undervalued to begin with (not at these low interest rates).

When an asset perceived as low risk or riskless outperforms other risky assets, either the world is ending, or that asset has risen so much that it’s now the investment with the highest chance of a correction.

We saw this phenomenon a few years back with housing. For years, real estate prices increased at a faster rate than income growth, even though the two typically matched over the long haul. The world didn’t come to an end when housing prices started their inevitable correction, although it did bring a lot of other overpriced assets down with it. Suffice to say, most investors no longer see real estate as a low-risk investment today.

In today’s low-yield bond environment, opportunities lie elsewhere.

Dividend-paying blue chips easily trump the yields on government bonds.

Stocks with a history of dividend growth will perform even better over the long-term. Since European stocks have suffered as the bond market has benefitted, there may be some opportunities in there.

Potential candidates for current income among European stocks include international food conglomerate Unilever (UN), infrastructure company ABB (ABB), and energy powerhouse Statoil (STO).

For the short-term, even cash with a zero percent return is a better opportunity than bonds, even if it’s stuffed under a mattress. Government bonds are trading at absurd prices.

Sadly, they may get worse before they correct.

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2012-51-10
Tuesday, 10 Jan 2012 08:51 AM
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