TAG | inflation
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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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Use These “TIPS” to Protect Yourself Against Inflation
0 Comments | Posted by Alexander Green in Alexander Green
Use These “TIPS” to Protect Yourself Against Inflation
by Alexander Green, Chief Investment Strategist
Monday, April 19, 2010: Issue #1241
A recent Communiqué column of mine, in which I recommended Treasury Inflation-Protected Securities (TIPS), outraged a number of readers.
Why was it so upsetting? Because – and don’t ask me what they’re smoking – 17% of Americans actually approve of the job Congress is doing.
Taking both parties to task, however, I wrote:
#1: When George W. Bush and his fellow Republicans came to power a little more than nine years ago, they promised to cut wasteful spending, limit the size of government and move closer to a balanced budget.
Instead, they…
- Created a Medicare drug entitlement that will cost nearly $1 trillion in its first decade…
- Started a string of expensive financial bailouts that continues today…
- Passed a record number of earmarks…
- Increased federal spending 58% faster than inflation…
- Presided over a $2.5 trillion increase in the public debt.
#2: Then, last November – anxious for change – voters threw the bums out and put the Democrats in charge. The Democrats promised to change this reckless course and restore fiscal sanity to the country.
Instead, they tripled the budget deficit in their first year. The White House and the Congressional Budget Office now estimate that this year’s deficit will explode to $1.56 trillion – a post-World War II record at 11% of the overall economy – and add $9.7 trillion in debt over the next decade.
Facts vs. Opinions
Here are the other points I made…
#3: The Obama Administration’s own projections see the federal debt hitting $18.5 trillion by 2020. However, that was before the passage of the healthcare reform bill – the biggest new entitlement since the creation of Medicare in 1965.
#4: Unfunded liabilities for Social Security, Medicare, Medicaid, the prescription drug benefit and the new federal healthcare program have now jumped to $108 trillion, nearly eight times our annual GDP.
#5: Moody’s has threatened to downgrade the Triple-A rating of U.S. sovereign debt, perhaps within three years. A drop in our credit rating would both decrease the perceived safety of Treasury securities and increase the interest that Uncle Sam – excuse me, you, your children and your grandchildren – will pay on the deficit.
#6: Credit Suisse recently produced a report pointing out that the country whose debt profile most resembles that of Greece is – hold your breath – the United States. (If you believe a picture is worth a thousand words, try this: http://www.usdebtclock.org/)
#7: Down the road, Washington – with the reluctant consent of the Federal Reserve – could opt to solve this problem the way so many governments throughout history have – by inflating our way out of it.
Inflation: The Bane of Debt-Holders & A Godsend to Debtors
Inflation is the bane of debt-holders, of course. But it is a godsend to debtors – and Uncle Sam is the biggest of them all – as they can repay fixed obligations with increasingly worthless currency.
What surprised me was not that some readers had a difference of opinion. I always welcome that. It was that respondents uniformly barked that they didn’t want to hear my “political opinions.”
Opinions? Go back through these seven points and tell me which one contains an opinion. Even the last one modestly states that Uncle Sam “could opt” to inflate our way out of this problem.
As Jack Nicholson reminded us in A Few Good Men, some people can’t handle the truth. Especially when it’s something they don’t want to hear.
For example…
- When we warned 11 years ago about the massive bubble in Internet stocks, the majority of respondents gushed about the New Era and insisted we “just didn’t get it.”
- When we warned six years ago about the ominous housing bubble, many scoffed and insisted that home prices “always go up.”
- When we talk today about the threat to your financial security that Washington is creating with its Ponzi-style entitlement schemes, a lot of investors don’t want to hear that, either.
Believe me, I hope I’m wrong. I don’t want high inflation any more than you do.
Fortunately, inflation today is as tame as a kitten.
The Benefits of Treasury Inflation-Protected Securities & Three Ways to Buy Them
I only suggest that you buy Treasury Inflation-Protected Securities ( TIPS) as an important insurance policy. (Because when inflation – the thief that robs us all – rears its ugly head, neither stocks nor bonds do well.)
You can purchase inflation-protected Treasuries (TIPS) in three ways…
- Directly ( http://www.treasurydirect.gov/indiv/research/indepth/tips/res_tips_buy.htm).
- Through the Vanguard Inflation-Protected Securities Fund (VIPSX).
- Through the ETF equivalent – the iShares Barclays TIPS Bond Fund (NYSE: TIP).
There are several advantages to buying TIPS…
- 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.
- The interest you receive is exempt from state and local (but not federal) income taxes.
- TIPS are less volatile than traditional bonds.
- They’re also excellent diversifiers.
Some investors complain that these securities haven’t done anything exciting lately. Of course not. We’ve been in the grip of disinflationary forces, not inflationary ones – and that won’t change next week or next month.
Protection Against The Government “Doing Something”
But as the deficit keeps expanding and the electorate grows increasingly unhappy, pressure will mount on the government to “do something.”
That “something” could be a decision to inflate our way out of this mess, rather than risk the kind of deflationary spiral that Japan has endured over the past two decades.
Bear in mind…
- The Fed has already taken interest rates close to zero…
- Congress has already tried a massive fiscal stimulus…
- The Federal Reserve has already created trillions out of thin air to mop up worthless securities.
If the economy stumbles again and further government action is taken, it could be even more reckless, resulting in inflation.
In the interest of full disclosure, however, that’s just my opinion.
Good investing,
Alexander Green
Editor’s Note: A lot has happened in the financial world since 1987. Bull markets… bear markets… inflation… deflation… upturns… downturns. The rise and fall of America’s biggest companies. Millions made. And millions lost.
And since that time – throughout all kinds of market conditions – The Oxford Club has helped its members generate $19 billion in wealth. Regardless of which direction our elected officials take the United States next… how much more debt we amass… or how high inflation goes, you can join this exclusive and elite group of investors and start profiting today.
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