A Greek Tragedy

You may not have heard this news, but Greece just had its bond rating cut to BBB by Moody’s. Now, you may be asking what the big deal is. After all, what does Greece’s credit rating have to do with my investments here at home? Well, just like you, countries have credit ratings. They issue bonds and borrow from banks just like a large corporation does. A downgrading of a country’s sovereign debt means they are likely in fiscal difficulty, and that’s never good.

One of the investment themes that I believe will take shape in 2010 has to do with large debt defaults from strong corporate and sovereign institutions that formerly were considered bulletproof. Now, many people here in the United States think we have the worst debt levels in the world. That’s in part why we are seeing the rush to own gold, and the rush to put money to work in international markets. Sure, we do have our debt problems in this country, but they are far from the lofty levels of dangerous debt many other countries hold.

A widespread sovereign debt crisis could rock the world’s stock markets, and it could even cause a stampede back into the U.S. dollar. I will be watching this Greek tragedy unfold in the weeks and months ahead, and I promise I will let you know if I think it will affect your investments here at home.

If we do see a sovereign debt meltdown, the crisis likely will show up first in the bond market. In last week’s radio show, I talked about how investors need to start paying attention to risk. Most people are aware of the risk in the stock market, but when it comes to the bond market, somehow people think that they can’t lose money.

So far this year, investors have poured more than $230 billion into bond funds. This is a huge amount of money, especially when you consider that only a net $2 billion was funneled into stock funds. This tells me that investors now are thinking that they are more properly diversified than they were last year. They reason that if stocks take a hit again, at least their bonds will buoy their portfolio. Well, I think this line of thinking is a big mistake.

Bonds can get hurt in two primary ways. First, if interest rates rise, the value of bonds falls sharply. A 1% rise in long-term interest rates will send bonds down 7-15%, depending on the type of bond. Second, there is credit risk. As I mentioned earlier, we are starting to see things happen in the bond market that rarely happen. A sovereign country going into default is a risk that nobody has really planned for, and a blowup in this market could really send the value of all sorts of bonds lower.

As of right now, the bond market is holding up fine. If, however, interest rates rise, and/or if countries around the world continue having their credit ratings slashed, it could spell bond market trouble.

One indicator of early bond risk is the trend in high-yield corporate bonds, otherwise know as junk bonds. As you can see from the chart above of the SPDR Barclays Capital High Yield Bond (JNK), junk bonds still are enjoying a solid uptrend thus far. But if this uptrend begins to falter, and if bonds start to lose their luster, then even those “safe” bond positions could be at risk.

If you want to find out how to protect yourself from the risk of a potentially substantial bond market downturn, then I suggest that you educate yourself by listening to a radio show that I taped last week. To listen to the show, just click here.