What in the world are bond investors thinking?
Have you seen the returns they are getting?
Per year, investors in 10-year sovereign bonds are receiving from the U.S. 2.34%, from Italy 2.33%, from Spain and the U.K. 2.14%, from Germany 0.80%, and from Japan 0.47%. In almost all of those cases, those returns are not even keeping up with inflation.
Yes, we all know these particular bonds are very safe investments which is why their yields are so low, which safety is important to investors in times of economic turmoil. But they are not entirely risk free.
By risk, I am not implying risk of one of those governments defaulting, which is indeed very slim. Rather, I am referring to the risk of missing-out on higher returns elsewhere. Plus there is one more risk which few bond investors take into account: the erosion of money over time.
A Bond’s Hidden Risk
While sovereign bonds issued by governments are considered among the safest investment vehicles anywhere, they do carry a risk that many investors never factor into their calculations when purchasing them.
A bond is essentially the buying of future money today. That is, when buying a 10-year bond, you exchanging a certain amount of 2014-dollars for 2024-dollars. While your money is tied up, you collect interest for as long as you own that bond.
But in determining if you are getting a fair deal for your investment, you need to look at more than just how much interest you are collecting along the way. You also need to look at what a dollar will be worth in 2024. Will the 2024-dollars you will be receiving then be worth more or less than the 2014-dollars you are paying out today?
Naturally, a dollar is always worth a dollar. But not over a period of time. A hundred years ago, for instance, one dollar would have bought you a dinner, as a 1914-dollar equalled 23.30 2014-dollars.
There are several factors at play that change the value of a dollar over time, but one of the most important ones is inflation. If inflation is positive, meaning prices are rising, then the value of a dollar in the future will be less than it is today. If inflation is negative, meaning prices are falling (which does happen, though very rarely), then the value of a dollar in the future will be more than it is today.
A bond investor purchasing that 2024 treasury bond, therefore, needs to estimate what a dollar will be worth in 2024 to determine if they are getting a good deal.
To determine this, many will compare bond yields to stock dividend yields to determine where the better return can be had. Some might figure that if a 10-year Treasury bond is yielding 2.34% while the dividend yield of a large cap stock like Bank of America is yielding only 1.17%, then the bond would be the better deal and they’ll lock their money in.
But there is one number few bond investors look at closely enough: the inflation rate. This is a very powerful variable that can have a devastating erosion effect on your money. Remember what inflation did to that 1914-dollar? It cut that dollar bill into 23.30 pieces and left us with just one of those tiny pieces, evaporating away some 95.69% of the value of that 1914-dollar over the past 100 years.
Take Inflation Into Account
So how can investors take inflation into account when determining what constitutes a better investment? We start with the current inflation rate and trend, as graphed below.
The current inflation rate sits at 1.7% per year, and has been averaging from 2% to 3% for the past 14 years, for the most part. Right off the bat we can see this spells trouble for long term bond investors.
Why? Because inflation is currently below its longer-term average, implying that at some point it will have to move back up to that average, most likely long before the next 10 years have passed.
What happens to bonds when inflation rises? Remember how inflation erodes the value of a dollar over time? When inflation rises, investors holding bonds will want to collect higher interest to compensate them for the depreciation of their money. For the interest rate of a bond rises, its price has to fall, as the only way a buyer can collect a higher yield is by paying less for the bond up front.
This means bond investors can expect bond prices to fall over time, and buying into them now would resulting in locking your money into a depreciating asset. Even if you decide to hold on to that bond until it matures 10 years from now, you would still be losing money.
Why would you be losing money? Aren’t you still collecting the interest that the bond pays? Yes, but that interest will not be keeping up with inflation, meaning that the 2024-dollars you get back will still be worth less than the 2014-dollars you paid plus the interest you collect along the way.
The table below shows recent U.S. Treasury auctions and the interest rate paid by each note, with the 10-year paying 2.25% per year. That rate is locked-in for 10-years, and will not change.
However, inflation will change. And as we have seen in the previous graph, the average over the past 14 years has hovered between 2% to 3%, and has even spent a significant time between 4% and 5.8%.
Now then, what good is it to collect 2.25% in interest from your 10-year bond in a single year when inflation for that year erodes the value of a dollar by 3%, 4%, 5% or more? The interest you are collecting from your bond would be too small to reimburse you for the erosion of your money.
Better Alternatives Than Bonds
Of course, bonds would be great in an era of falling inflation or a period of falling interest rates, since you would have locked-in higher rates while current rates fall. We have been in just such an era for a few years since the 2008-09 economic crisis, which is why so many investors have poured into bonds, pushing their yields down to such historically low levels.
But we are not going to be in this environment much longer. In fact, the central bank has even promised us it will do whatever it has to to bring inflation back up to its 2% target. What will that do to today’s 2.25% interest rate on the 10-year bond? It will effectively cancel its two percentage points, leaving you with just 0.25% interest per year for the next 10 years. And if inflation rises more than 2.25% for any period of time – as it has many times in the past – today’s 10-year bond would be losing you money.
Yet there are plenty of better investment opportunities out there which are just as safe as those Treasury notes, such as simply buying a high dividend paying large cap stock. Technically, of course, stocks are riskier than Treasuries if you look at default probability alone. But when you factor in the price appreciation of stocks over time and the erosion of a dollar over time, now we come to a vastly different conclusion: Treasuries are actually riskier than large cap stocks.
Take one of the market’s favorite dividend plays, AT&T (NYSE: T), currently yielding 5.15% per year in dividends. Holding T’s stock for a year would pay you as much as 2.2 years’ worth of time invested in a 10-year note.
However, as noted in the graph below, stocks carry volatility that bonds do not have. Really? Is it really so that stocks carry volatility that “bonds do not have”?
Not at all. In fact, knowing as we do that bonds are at their lowest yields in decades and really have nowhere to go but up means that bond prices really have nowhere to go but down, implying depreciation of your capital. Whereas stocks do have plenty of upside potential as the economy continues to recover.
Besides, those occasional stock market corrections are golden opportunities to add to your position at cheaper prices, locking-in even higher yields than the 5.15% that T is currently paying, as an example. After these corrections, when markets rebound as always happens given enough time as evidenced above, investors will earn capital appreciation from a rising stock price in addition to the higher yields they are receiving over bonds.
Taking stock appreciation into account now makes even that Bank of America yield of 1.17% seem palatable, since the stock itself has appreciated some 380% since hitting its 2009 low for an average gain of more than 67% per year. (Be careful mentioning this to a bond investor.)
Hence, when determining what makes a better investment, we need to remember to factor-in inflation. And not just the current rate of inflation but the projected future rate of inflation as well.
Of this we can be certain: bond yields are at their multi-decade lows with nowhere to go but up, bond prices have nowhere to go but down, and inflation has nowhere to go but up – by the Federal Reserve’s very own promise. Do yourself a favor and get out of bonds, or you will be missing the second half of an equity bull run unlike any we have seen in a generation.