TAG | Deflation
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U.S. Treasury Bonds: Why the Safest Investment is Now One of the Riskiest
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U.S. Treasury Bonds: Why the Safest Investment is Now One of the Riskiest
by Alexander Green, Chief Investment Strategist
Tuesday, June 1, 2010: Issue #1271
U.S. Treasury bonds are the safest investment in the world.
However, that doesn’t mean they can’t be dangerous. Far from it.
Yet a few days ago, The Wall Street Journal reported that, “Long-dated Treasury securities are now the most favored financial assets for global investors fleeing the eurozone’s debt crisis.”
Talk about jumping out of the frying pan and into the fire…
Don’t get me wrong. I’m not one of those end-of-the-worlders who expect the U.S. government to default on its sovereign obligations. That won’t happen.
It wouldn’t even be necessary. After all, history shows that governments always prefer to inflate their way out of a debt crisis by cranking up the printing presses instead. That way they can achieve a de facto debt reduction simply by devaluing the currency.
If you’ve seen the photographs of German citizens hauling wheelbarrows full of cash into the bank during the days of the Weimar Republic, you know what I’m talking about.
Of course, I don’t expect inflation like that. And neither should you.
But what kind of inflation does an investor expect who loans his money to the government for 30 years at a rate of just 4.1%?
Why U.S. Treasury Bonds Could Bulldoze Your Portfolio
That 4.1% figure is the current yield on the long end – and it’s a bet that has a little upside potential and a whole world of downside risk. Why?
Imagine a seesaw with interest rates and inflation on one end and bond prices on the other. If inflation goes down, bond prices go up. And vice-versa.
But how far down can rates go on the long end? Unless we have the sort of deflationary environment that Japan suffered in the 1990s, the appreciation potential here is minimal.
On the other hand, if inflation rears its ugly head, long bonds will get clobbered. And the worse inflation gets, the worse these bonds will do.
I realize that inflation is not an immediate threat. Technology and deregulation have brought costs down over the past decade. And even oil prices have moderated lately.
But if the bond market gets even a whiff of higher inflation, these bonds will drop like a stone. And I’m betting that investors who weren’t around during the early 1980s – and even many who were – don’t realize it.
They are so busy patting themselves on the back for eliminating default risk – and picking up a 4% yield versus next-to-nothing on the short end – that they are forgetting about interest rate risk: the risk that higher inflation will send long yields soaring and bond prices crashing.
Don’t Let the Government Trick You into Speculating
Seth Klarman, President of the Baupost Group, an investment firm in Boston that manages $22 billion, says the U.S. government is inadvertently provoking its citizens into taking very bad risks right now.
How?
“By holding short-term interest rates near zero, the government is basically tricking the population into going long on just about every security except cash, at the price of almost certainly not getting an adequate return for the risks they are running. People can’t stand earning 0% on their money, so the government is forcing everyone in the investing public to speculate.”
Of course, most people aren’t exactly in a speculating mood right now.
So what are they doing? They’re buying super safe long-term Treasuries and earning over 4%.
Except that’s not a safe investment – as many will eventually learn to their chagrin.
Good investing,
Alexander Green
Editor’s Note: Are you concerned about the direction in which America’s elected officials are taking the country? Worried about ever-increasing debt levels? Fearful of major inflation down the road?
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Treasury Inflation-Protected Securities (TIPS): The Indispensable Investment
0 Comments | Posted by Alexander Green in Alexander Green
Treasury Inflation-Protected Securities (TIPS): The Indispensable Investment
by Alexander Green, Chief Investment Strategist
Monday, May 10, 2010: Issue #1256
Two weeks ago, I wrote a column recommending Treasury Inflation-Protected Securities (TIPS) as protection against potential inflation down the road.
It prompted a flood of questions and challenges. I want to address those, but let me start by briefly re-stating my case:
- Unprecedented government spending – including $108 trillion in unfunded liabilities for social security, Medicare and new universal healthcare benefits – is putting the nation at risk.
- With interest rates near zero, the Federal Reserve cannot take one traditional step – lowering short-term rates – to revitalize a weakened economy.
- In a severe economic downturn or double-dip recession, politicians – with the reluctant assistance of the Fed – could opt to spend even more massively to try to jump-start the economy.
- The result could be stagflation: slow growth with higher inflation. (And although we haven’t seen it here in almost 30 years, perhaps even hyper-inflation.)
I don’t know what the odds of this happening are – and neither does anyone else. But I think investors would be foolish not to at least consider the possibility…
Inflation or Deflation? Hedge Your Bets This Way…
Respondents who disagreed generally fell into one of two camps…
- They either believed that deflation is more likely than inflation.
- They thought inflation was likely, but since Congress will almost certainly be the culprit, they don’t want to reward the mischief-makers by buying any kind of government securities.
Let me handle the former objection first: Is deflation more likely than inflation? Perhaps. No one can say. You should probably own a good slug of Triple-A insured municipal bonds just in case. (Because future tax rates are almost certainly going higher.)
By all means, make some plans for a deflationary scenario. But plan for the possibility of inflation, too. This is what diversification is all about. Hedge your bets.
But why use TIPS as your hedge, rather than a traditional inflation hedge like precious metals? In my view, you should use both. But remember, gold and silver are less than perfect hedges.
They have both performed exceptionally well over the last 10 years, for example. Gold has more than quadrupled. Silver has done even better. But the 20 years before that were an unmitigated disaster.
But no matter whether inflation is low or high, TIPS will protect you. How?
The Benefits of Buying Treasury Inflation-Protected Securities
- Regular Interest Payments: TIPS pay interest every six months, just like a regular Treasury bond. But unlike traditional bonds, your principal increases each year by the amount of inflation, as measured by the consumer price index (CPI). Semi-annual interest payments also increase by the amount of inflation.
- Tax Benefits: The interest you receive is exempt from state and local income taxes (but not federal). TIPS are also less volatile than traditional bonds and are also excellent diversifiers.
There are three good ways to buy inflation-protected Treasuries:
- Directly: http://www.treasurydirect.gov/indiv/research/indepth/tips/res_tips_buy.htm
- Through the Vanguard Inflation-Protected Securities Fund (VIPSX).
- Through its ETF equivalent – the iShares Barclays TIPS Bond Fund (NYSE: TIP).
I recommend TIPS for two primary reasons…
- I’m not a moralist trying to claim the high ground. I’m just trying to protect myself, my family and my heirs from potentially destructive hyper-inflation. I don’t want to remain true to my free-market principles only to see the net worth I’ve accumulated over a lifetime torpedoed.
- There is no private-sector alternative here. For good reason, private and public companies don’t want to leave themselves vulnerable to sky-high interest and principal payments down the road if inflation takes off. So they don’t issue inflation-protected securities. That makes TIPS the only game in town.
I know that some libertarians and laissez-faire capitalists will refuse to buy Treasury securities, period. But as I’ve pointed out, other inflation hedges sometimes don’t work. So there is no small risk taking another approach.
In sum, there is only one investment that guarantees a return that exceeds inflation in the years ahead: TIPS.
And in my view, that makes them an indispensable part of your portfolio.
Good investing,
Alexander Green
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