I would not buy US treasuries and I don’t understand why there is even a market for them.
I know the Federal Reserve is a big part of the “market”, officially and otherwise, but surely they aren’t 100% of the “market” (yet).
If the Fed isn’t 100% of the market that means someone besides the Fed is still buying treasuries.
I would like to talk to someone who is buying US treasuries and understand WHY they are doing so.
US debt yields are paltry. As of today the 10 year treasury has a 1.5% coupon. That means if I buy a $100, 10 year treasury, I’ll get $1.5 per year, in two $.75 payments and after ten years I’ll have gotten $15, plus the $100 face amount of the treasury.
Ten year treasuries are trading at a discount rate of $97.89 so if I hold the treasury to maturity, I could gain $17.11 ($1.5 per year times 10, plus $2.11 (difference between the bond price and face value)).
Price from Bloomberg: http://www.bloomberg.com/markets/rates-bonds/government-bonds/us
In other words if I were to purchase a 10 year treasury I’ve loaned the government $97.89 and ten years later the government pays me back $115. While $17.11 isn’t fantastic it looks positive.
The problem is price inflation.
The 2015 consumer price index (CPI) was 1.7%. So using a handy inflation calculator (link below), I know that $115 ten years from now has the same purchasing power as $97.16 in today’s dollars.
Basically, I would have loaned the government $97.89 and in ten years they pay me back with the purchasing power of $97.16.
I’ll have lost purchasing power!
When I loan someone money (unless I really like them) I should be compensated for not having access to those funds. I certainly don’t accept being paid back with less valuable money when I make an investment.
Personally, I don’t think the CPI is accurate. I think that price inflation is at least 2%, perhaps even as high as 10% per year. So let’s say prices are rising on average 5% per year.
With a 5% annual price inflation rate, that $97.89 is worth just $70.60 ten years from now, so the ten year treasury lost over $27 in present day purchasing power.
If you reinvest the bond coupon payments (the $.75 you get every six months) you would start taking advantage of compound interest and the math works out a little better.
The calculations become much more complex but if I were to reinvest the coupon payments, best I can tell is the $97.89 would grow to around $135 after ten years. With a 5% inflation rate the $135 would be less than $83 in today’s dollars so it is still a loser investment. That assumes the 10 year continues to trade at the current price and the coupon stays the same for the treasuries purchased with the reinvested coupons.
If I were to reinvest the coupons and if inflation really was 1.7%, the $135 ten years from now would be around $114 in today’s dollars, so I will have gained purchasing power.
But as I said before I don’t think inflation is that low.
Short Term Treasuries are No Good Either
The 12 month treasury pays no coupon but sells at a discount such that it yields .64% upon maturity. With inflation at 1.7% it is another situation in which a buyer is guaranteed to lose purchasing power if the treasury is held to maturity.
The only way to gain real value with a treasury would be to sell the treasury for more than the purchase price by a wide enough margin to beat the rate of price inflation or to hope that there is significant price deflation.
The Federal Reserve will fight any price deflation that might occur so I don’t think that will work. I also think that bonds are in a bubble, so while right now there might be an ample source of greater fools willing to pay more for a bond than the last person, eventually the only greater fool will be the Fed.
Again, I don’t understand why any rational investor would loan money to the US government in exchange for being paid back with dollars that are less valuable later. It’s the opposite of how the time value of money is supposed to work and it isn’t sustainable.
It’s one of the reasons I think bonds are in a bubble. I’m not the only one who thinks that. Folks much smarter and experienced than I have been saying the same thing.
The takeaway for me is don’t buy US treasuries. They are reward-free risk and there is no place for them in my portfolio.
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