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The following chart shows how we would have done if we also factored in a tax rate of 35%.
On average, if history is any indicator, we would not expect to make any money buying the 10-Year Treasury and holding it for 10 years if we were in the 35% tax bracket. Those who made money in the 1980s and 1990s had their fun, but that era is quite possibly coming to an end.
Since we do not know what the inflation rate will be over the next 10 years, we cannot know how today's 10-Year Treasury purchases will do. We can come up with some estimates though.
Let's start with the 10-Year TIPS. It currently yields 1.29%. That is an inflation adjusted yield and as such is directly comparable to the yields in the first chart. It's a bit low compared to the average and the median, but there have certainly been periods when real yields were lower.
The 10-Year Treasury currently yields 3.69%. If we subtract the TIPS real yield of 1.29% from it then we are left with an inflation expectation of 2.4% over the next 10 years.
If we were to buy the 10-Year TIPS today and inflation really did average 2.4% over the next 10 years, then we would make 3.69% per year. After 35% taxes, that would yield a return of 2.4%. Since inflation would also be 2.4%, the yield after inflation and taxes would be 0%. That is slightly lower than the median and average values in the second chart, but barely enough to even mention.
For those being taxed at 35% (I'm not one of them), each 2.86% rise in inflation above that which is expected lowers the after tax yield of the 10-Year TIPS by roughly 1% (0.35 * 2.86% = 1.0%). This is why I root for very low inflation even though I own TIPS. As a saver, inflation never helps me.
For those who own treasuries that are not inflation protected, each 1% rise in inflation above that which is expected lowers the after tax yield by 1%. Unexpected inflation hurts them nearly three times more.
Is there a bond bubble in 10-Year Treasuries? I see no compelling evidence here one way or another. It all depends on what inflation does next. I think we're still fighting deflation but want the inflation protection just the same. I could be wrong to think this way though.
I can say that it makes me nervous that our country is taking on massive amounts of debt. There can be a bond bubble without inflation. All it would take is too much debt supply and not enough debt demand. That said, at least when I buy TIPS directly from the government and hold them until maturity I do get some inflation protection. I may end up being a fool, but at least I know that I don't require a greater fool to sell them to.
Source Data:
U.S. Treasury: Daily Treasury Yield Curve
St. Louis Fed: CPI-U
St. Louis Fed: 10-Year Treasury
7 comments:
Just back from vacation so I am not really ready to do any real thinking. It does appear that most set investments (bonds, etc) have such a low (if any return) at this point if forces one to play at the risk casino. Almost like it was planned that way! My cynicism has returned from vacation as well it seems!
Good post, thouhg my word verification is "dumbo".
GYSC,
Welcome back!
It does appear that most set investments (bonds, etc) have such a low (if any return) at this point if forces one to play at the risk casino. Almost like it was planned that way!
That's just it though. Real yields aren't really all that low when compared to the long-term averages.
I think people are taking on extra risk because real yields are low compared to the 1980s and 1990s.
News flash... the 1980s and 1990s were a seemingly very prosperous period and will not be soon repeated.
My cynicism has returned from vacation as well it seems!
Hahaha! Mine continues on, as usual.
Stag,
I have a similar chart but for some reason the periods of negative yields are fewer and less drastic.
I use the Ten Year Yield less the yoy inflation rate based on monthly data. I didn't inflation adjust the data, but that doesn't account for the descrepancy.
Something seems off. It's hard for me to believe that lenders would have tolerated negative yields for so long (from the early 60s thru the late 80s).
I'm scatching my head here.
Stag,
Never mind. I see what you did.
But our two charts do highlight the risk of investing in long dated treasuries with low current nominal yields, decent current real yields and rising inflation. In short, you get creamed!
I think I shared this with you before, but I did an analysis of short and long yields around the Great Depression.
During the 1930s bust, those with long term treasuries did great, but then paid the piper in spades during the 40s & 50s. It would have been worse if the Fed had not been supporting the long treasury market too.
Short term treasury yields were also awful during the 40s & 50s (negative on a real basis) but at least you wouldn't have been stuck holding large capital losses when inflation finally arrived. At today's tax rates, for the passive investor there wouldn't have been that much difference between long and short government bonds over the full deflation/inflation cycle. Especially if one accounts for the inverted yield curve for a few years prior to 1929.
I don't see high inflation in the near future, but I also see very limited upside to longer term treasuries. I tend to believe Bernanke can prevent an all out deflationary bust. And even if we fall into a Japan sytle deflation, the returns after taxes will be modest. Of course modest beats negative.
In any event, I definitely don't see a return to propserity any time soon.
mab,
I don't see high inflation in the near future, but I also see very limited upside to longer term treasuries. I tend to believe Bernanke can prevent an all out deflationary bust. And even if we fall into a Japan sytle deflation, the returns after taxes will be modest. Of course modest beats negative.
As a saver these days, we should feel lucky to have any returns after taxes. Modest does indeed beat negative.
Stumbled upon this by accident, but I felt like commenting. You missed on big point. People buying bonds in the early 80s would have enjoyed some fat capital gains, especially if they were trading them. Check out any well managed bond fund, and you'll see some pretty good returns. No one should ever "buy and hold" a fixed income security. You should always play the yeild curve. And if you can't do it, find a manager who can. For example, we'll probably see a rush upwards of the ten year to near 4% levels, but we will see the rate fall as low as 1% in the next 2 and a half years.
Check out any well managed bond fund, and you'll see some pretty good returns.
Then my personal bond fund must be especially well managed. I've been buying bonds since 2000 as part of a TIPS bond ladder and the market currently thinks each and every one of them now deserves a premium. Further, I managed to get nearly 25% of my entire investment nest egg into I-Bonds (the ones I bought in 2000 continue to pay 3.4% above inflation and will continue to do so for 19 more years).
No one should ever "buy and hold" a fixed income security.
So every person in America who owns a CD ladder is a moron? (I actually own a TIPS ladder because I prefer the inflation insurance.)
You should always play the yeild curve.
I should always gamble (play) thinking that I am so much smarter than the bond market overall? Really?
I shouldn't use any long-term thinking to predict where yields might be a decade from now?
And if you can't do it, find a manager who can.
Because paying a manager fees to gamble on my behalf will help my returns enormously in this low real return yield world?
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