Investors should not be surprised with what has been happening in the bond market so far this year. We have been warned for several years that if our federal budget deficit wasn't brought into balance, there would eventually be dire consequences. Think back: How many times during the past few years have you heard Chairman Paul A. Volcker of the Federal Reserve deliver that message before congressional committees?
In the early 1980s interest rates soared in the United States and the dollar was eagerly sought by foreigners who wanted to purchase our high-yielding fixed-income securities. Eventually the dollar became so strong in the foreign exchange market that our trading partners were begging for relief from the dollar's strength. In time, inflation subsided, interest rates declined and, thanks to the tax cuts of 1981, the economy began its recovery in earnest in 1983.
But along with the new Reaganomic policies came ever-increasing deficits. Since Americans saved a low percentage of their income, foreign funds were needed to finance our deficits. As Americans were on a consumer binge and the dollar was so strong, consumers began importing a myriad of products. This in turn helped create an expanding trade deficit.
Concurrently, the broader measure of our external debt, the current-account balance, also began to grow. In fact, by the end of this year, it is estimated that our external debt will be around $250 billion, which will make us one of the largest debtor nations in the world.
In early 1986, the United States began to nudge the high-flying dollar to lower levels. In February, the dollar's decline picked up steam and analysts began to perceive that their worst fears could become reality. Foreign investors, already stung by the depreciation of the dollar, demanded a "premium" of higher yield to compensate for further possible declines in the dollar.
So for now, it is important for investors to protect their principal in a period of increasing interest rates. Longer bonds with losses could be sold with the losses being used to offset gains realized in the stock market. The proceeds from the sales could then be placed in a short-term money market fund until the interest rate outlook is clarified. Now is certainly the time for caution.
James E. Lebherz has 28 years' experience in fixed-income investments.