Hardly anyone imagined the day would come when AAA bonds would be downgraded to junk status on a daily basis. But that's exactly what has been happening to bonds backed by subprime mortgages in these last few months. And, in fact, Bob Prechter not only imagined this very thing happening, he also wrote it down in his groundbreaking book, Conquer the Crash: How to Survive and Prosper in a Deflationary Depression. Read an excerpt from his chapter about bonds below.
But first take a look at this chart that shows how a company that provides bond insurance has taken a beating over the past seven months. Ambac Financial Group, which guarantees commercial and municipal bonds, is just one bond insurer being hurt by concerns over the declining value of the bonds they have insured. And, to top it off, bond-rating agencies have promised to review the AAA ratings of the bond insurers themselves. When will it end?
* * * * *
Excerpted from Conquer the Crash, by Robert Prechter
Today's "High-Grade" Bonds
Don't think that you will be safe buying bonds rated BBB or above. The unprecedented mass of vulnerable bonds extant today is on the verge of a waterfall of downgrading. Many bonds that are currently rated investment grade will be downgraded to junk status and then go into default. The downgrades will go hand in hand with falling prices, so you will not be afforded advance warning of loss. When the big slide begins, I doubt that the rating services will even be able to keep up with the downgrades at the rate that they will be required.
Owning government bonds also involves a political risk. Governments have a long record of stiffing their creditors in a crisis, and no government is immune from adopting that solution to its financial problems. A new regime especially may have little regard for previously squandered credit.
Today, millions of individuals and institutions own tax-exempt municipal bonds. While there are assuredly many exceptions, this class of bonds is the riskiest among popular government issues. In the United States, defaults on municipal bonds could occur at any moment after times get difficult. Politicians in many jurisdictions have borrowed and spent way more money than is likely ever to be paid back. Merely paying the interest on that debt in tough economic times will become an acute problem for many issuers. In such cases, default for many cities and counties will be inevitable. Even the debt of some higher-level government agencies is at serious risk of default in a worst-case scenario.
So if conventional wisdom is wrong, what is the correct way to frame the problem of investment opportunity and risk with respect to bonds in a deflationary depression?
[Editor's Note: The answer to this question is on the last page of Chapter 15 of Conquer the Crash, titled "Should You Invest in Bonds?" See below for information on how to purchase this uncommonly useful book.]