MAKING SEN$E -- May 24, 2012 at 4:57 PM ET
Do You Get Back All Your Money From a U.S. Bond?
A trader works at the New York Stock Exchange. Photo by Scott Eells/Bloomberg via Getty Images.
Paul Solman frequently answers questions from the NewsHour audience on business and economic news on his Making Sen$e page. Here is Thursday's query:
Name: Sam Katz
Question: Even though government bond prices fluctuate daily, wouldn't you get back your original investment if held to maturity plus interest along the way?
Paul Solman: Strictly speaking, yes, but suppose the interest rate on a government bond is weirdly low when you buy it? Then, if you're bond doesn't mature for a decade, say, you'll be getting back a lot less than you would have had you put your money elsewhere.
It's simple to understand but sometimes hard to remember: An interest rate is determined by several factors. One is impatience -- how much will you pay to use someone else's money right now? (This is sometimes called "the time value of money".) In addition, any interest rate is influenced by two risks. The first risk is default. The second is inflation.
So let's take the three factors one at a time. The historical cost of impatience? A reasonable guess is in the vicinity of 2 percent per year. Default risk? Well, even for the United States, it's greater than zero, wouldn't you say, Sam, given all the talk about debt ceilings, downgrades and the like? Finally, inflation. It has been running at 2-3 percent per year of late.
To lend your money for a decade, then, wouldn't you suppose the United States should have to be paying you something like 4-6 percent in interest? Which, it just so happens, is the range in which the U.S. 10-year bond has fluctuated for more than a century?
And yet, as I write (let me go to Bloomberg.com for a moment), the United States would have to pay less than 1.8 percent a year to borrow for a decade.
Why so low? you well might ask. The answer would appear to be: because pretty much every other investment in the world looks like an even worse bet.
But your question is whether or not you get back your "original investment." Sure. But how much would that investment be worth if inflation accelerates in the meantime? What if the United States flirts with default and interest rates are driven sky high? Will you be content to get 1.8 percent a year while your fellow Americans can buy a US. bond that pays its usual 4-6 percent? Or, as happened in the early '80s, more than 10 percent? In Warren Buffet's February letter to shareholders, he quoted a comment made by professional investor Shelby Cullom Davis long ago: "Bonds promoted as offering risk-free returns are now priced to deliver return-free risk."
I must admit, and often do, that more than half the assets my wife and I hold for retirement are invested in a way to protect against inflation: in TIPS (Treasury Inflation-Protected Securities). At least that covers us if inflation spikes. But if the global economy becomes more secure and other investments seem less risky, our TIPS may lose value compared to what they're worth today. In other words, even they appear to be a risky investment.
A few months ago, my rightly revered friend Andy Tobias, a longtime TIPS enthusiast, wrote that not only had he exited bonds, but, "I'm even out of the TIPS that have appreciated so nicely -- because they have appreciated so nicely. When first suggested, they yielded a ridiculously good 4.25 percent above inflation. Today, depending on their maturity, they yield little or nothing above inflation (and, because they sell at a premium, may actually carry a small negative yield). Going forward, they may not hedge inflation as well as stocks or real estate."
But, Tobias notwithstanding, I continue to ask myself: What's safer than TIPS? I still don't have a good answer. Meanwhile, Vanguard's TIPS mutual fund (and ours), VAIPX, has appreciated by nearly 1.5 percent since Andy wrote the above, while it also yielded an interest rate that matches inflation and gets reinvested in the fund, in effect buying us more shares.
But if I was nervous before reading Andy's post, which I just came upon recently, I'm even more nervous, post-post.