Dear Shareholder:
A Longer Term View: I suppose everybody knows by now that the Federal Reserve Board did not raise the fed funds rate at its August 8th meeting. This confirmed the predictions of many of the nation’s most reputable fed watchers and so the bond market, which had anticipated no rate increase, improved only slightly in the hours after the news was known. Then, in the next couple of weeks the bond market has actually improved further, with long term municipal yields declining about a fourth of one percent. This produced about a 2% increase in the price of our shares.
For the longer term this suggests that the Fed has completed, or is close to completing its two year cycle of gradually raising the fed funds rate. Perhaps the next move by the Fed will be to begin lowering rates, possibly sometime in 2007. But this is pure speculation and a long way off. There are a series of long term problems hanging over our heads for which we either cannot or have not yet found a solution. I’ll name three, each of which will affect the bond market in one way or another.
There is the oil problem. World demand seems to be closing in on world supply. And, world supply is strained by Middle-East wars and poorly maintained Alaskan pipelines. What would a price spike to $100 a barrel do to the bond market?
You would think an oil price spike would spur the Fed into raising rates again to counter the inflationary forces such a price rise would create. But you might have to think twice. A sudden oil price rise of this magnitude might have a depressing effect upon our economy, resulting in lower interest rates and a rise in bond prices. So it is not certain that higher oil prices mean lower bond prices as some analysts believe. Meanwhile, oil is down in price as of the last week in August.
There are those who worry that the economy may weaken, led by falling real estate values. If that does occur it should have the effect of strengthening bond prices as money flees to quality. Interest rates would fall (bond prices would rise). So a weaker economy or a real estate bubble pop is less of a threat to bonds, in fact it may be a help to bonds. Lately, real estate is showing signs of slowing down as evidenced by lower sales of existing and new homes.
Finally, there is the threat of international terrorist attack. If something on the scale of 9/11 occurs, this can only start a flight to safety, enhancing the price of bonds.
All of this has encouraged some folks (notably one is Bill Gross of PIMCO) to predict a year or two of stronger bond prices. I think I can join that crowd. This is not to say that the long term problems of a needed Social Security fix and a reduction in the national debt don’t loom large somewhere down the pike, but Congress typically does nothing about these macro problems until they are forced to do so. Meanwhile, I think our July 5th share price lows on every series we manage will be the low point in this last cycle of bond prices for a year or more.
Experience tells us that predicting markets a full year in advance is risky. Too many things can change, (such as, the rate of inflation). So I wouldn’t bet the ranch on bond prices having passed their lows, but if I had some money on the sidelines waiting for the bond market’s low, I think I would put that money back in the market now.
Bearer Bonds, Stock Certificates and Risk: Remember the days of bearer bonds and registered stock certificates? When you bought a bond or stock you had not completed the transaction until you took possession of the actual paper certificate. Stocks were registered in your name, which provided some deterrent to a thief, but bearer bonds were like a $1,000 bill. If you had a bearer bond in your possession you could cash it. It was not registered. Furthermore, coupons were printed for every payment date and attached to the bond in sheets. Once a coupon’s due date had passed the coupon could be cashed by whoever had it in their possession simply by clipping it off with scissors and presenting it for payment at a bank.
This led to some unusual situations. For instance, when our offices were in Harlan, Kentucky, we had a client who would go to her bank once a year; get out about a million dollars worth of municipal bonds; put them in a big shopping bag and bring them up the street to our office for coupon clipping. She would throw the bag up on our receptionist’s desk and say “shear my sheep”. Hours later we would deliver her a check for, say, $45,000 which was all tax-free. Then she would take her bonds back to her bank.
Fortunately, no one ever figured out what she had in her shopping bag!
Sounds like the good old days of regulatory laissez faire, doesn’t it? But it had its’ own set of problems too. If you lost one of these bonds, it was just gone; and the person that found it, or stole it, could cash it fairly readily. You could take out an insurance policy that would allow you to replace a lost bond, but it was very expensive.
Once, when I was very young, my father had me take a $500,000 box of blank bonds to Hyden, KY to get them signed. Once they were signed we were to ship them to Louisville by registered mail. The Hyden bank refused to mail the signed bonds because they said they didn’t have an umbrella shipping insurance policy. So I put them in the back seat of my car and drove them to Hazard where a bank had agreed to do the shipping. When I returned to tell my father I had gotten the bonds shipped he nearly had a conniption fit. He pointed out, not too gently, that Dupree & Company was solely responsible for those bonds from Hyden to Hazard, one of the most unsafe roads in Eastern Kentucky. And I thought I had been so clever!
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