Authors who manage to make a living without writing bestsellers tend to worry about their future income. That’s because authors who make a living without writing bestsellers aren’t stupid.
I plotted the history of 5 and 10 year Treasury Inflation Protected (TIP) notes auctions this week because I couldn’t find the data in a clean graphical form on any financial websites I checked. I own a couple of these notes which I purchased as an experiment back in 2010 when I became aware of them. At the time I intended to park most of my savings in TIPs if it worked out.
The 10 year notes I bought yielded around 1.7% (before the inflation adjustment) and the 5 year notes yielded 0.5% before the inflation adjustment. It’s impossible to include the future inflation adjustment in the yield (the equivalent annual interest rate) because future inflation isn’t known, although conspiracy theorists probably believe it is. I couldn’t find any other set of economic data that matched the shape of the graph, though the Fed funds rate came closest. The lack of a good match indicates that the pricing of inflation protected notes is largely driven by the news and psychology of the day.
The reason notes and bonds are characterized by a yield rather than a simple interest rate is that the price per $100 of face value is determined at auction. The interest rate is fixed for the life of the bond or note and is announced prior to the auction. Regular folks like us can establish a TreasuryDirect account (free) to buy directly from the government at the price determined at auction by the big boys, a process known as noncompetitive bidding. If the price per $100 of face value for the note or bond is less than $100 (which used to be the norm), that savings is known as a discount. So when I bought a 10 year note for $97 per $100 of face value, the value of the 3% discount could be diced up and added to the annual interest rate to determine equivalent yield.
As somebody who is more concerned with losing my savings to future inflation than riding our Ponzi scheme of a stock market to untold riches, I was quite happy with the result of that auction in the Spring of 2010, and was ready to go all-in at the next auction. Unfortunately, by the end of the summer, people were so desperate to protect their savings that the yield of TIPs went negative.
The interest rate was still a positive (if negligible) percentage, but the auction price for $100 of face value soared above $100, even above $110. In other words, people were willing to lock in a loss (after the inflation adjustment and taxes) just for the guaranty that their savings wouldn’t vanish is a wave of hyperinflation. They are still buying 5 year TIPs at a guaranteed loss today. I wasn’t that desperate, I left my savings in the bank earning next to nothing and the hyperinflation hasn’t happened yet.
What I didn’t realize back in the Spring of 2010 was that I didn’t have to wait for the next auction. The same day the results became public, I could have used any broker to simply buy the same notes (or older existing notes that would have yielded approximately the same at that point, regardless of their original auction pricing) at nearly the same price. I had believed that buying Treasury bonds and notes through a broker was a game for the rich and hadn’t even bothered looking into it.
Last week I purchased a 30 year inflation protected bond that yielded 1.4% for my IRA through an Internet broker (eTrade via BondDesk) just to see how that would work. The bond I bought was originally auctioned by the Treasury several months ago. The broker offers both a buying and selling price for the given bond or note, with the spread between the two representing the broker’s profit, just like “buy” and “sell” prices of currency shops at airports.
At this point, I own (small amounts) of all of the inflation protected financial instruments offered by the U.S. government: I-bonds (a savings bond product), inflation protected treasury notes, and inflation protected treasury bonds. The savings bonds and the treasuries differ in how they deal with the inflation adjustment and the interest, how deflation affects principal, the tax treatment, and redemption possibilities if you need your cash back.
The Treasury notes and bonds (but not the savings bonds) can also be held through mutual funds or ETFs. I owned the TIP ETF for a few years in my IRA, selling only when Bernanke begin making noises about raising the interest rate. Unfortunately, a large percentage of people who own bond funds of all sorts are unaware that they can lose a substantial chunk of their investment when the interest rate changes.
I’m thinking about writing a short book on the subject of buying Treasury bonds and notes for individuals, maybe I’ll just do an eBook. The truth is, I’ve come to find this stuff rather fascinating, though I plan to focus to the how-to aspects rather than the potential economic outcomes. The timing couldn’t be worse in the sense that bonds and notes have reached the end of a historic run-up in value, and prices will collapse at some point as interest rates rise. But another way to look at falling bond prices is the example of the 30 year bond I bought last week for nearly 20% less than somebody who bought it a few months ago, which translates into almost 0.8% in higher annual yield.
For the individual bond holder who doesn’t intend to trade Treasury bonds before maturity, the price of the bond doesn’t really matter as long as the owner is satisfied with yield above reported inflation. The regrets come if the Treasury reverts to selling inflation protected bonds and notes at a much higher interest rate or a much greater discount, in which case, owners of lower yielding bonds feel they could have done better by waiting.
Whether or not the Treasury will be required to offer higher yields on inflation protected bonds and notes as the interest rates rise isn’t knowable since it depends on human psychology. The yields on non-inflation protected securities will surely rise as the Fed funds rate is raised, but we could be entering an extended period when inflation fears continue to trump actual returns, and the government funds its (our) debt at a loss to lenders. And that’s fine by economists and bankers who in private believe that “saver” is a synonym for “sucker who funds other people’s excess spending.”