Bond Investors Have Been Warned

June 24, 2011
What would a Default on U.S. Debt Look Like?

Bond investors have been warned to stick with shorter-dated U.S. debt like short-term 1-5 year TIPS (NYSEArca: STPZ) and short-term 1-3 year Treasuries (NYSEArca: SHY).

Generally speaking, have investors been rewarded by heeding the warnings offered by mainstream financial entities?

You will note that the following contrarian warning is not mentioned.

Short-term TIPS earn -0.5% per year for the next 30 years, inflation averages 6% over the period, and investors sit in the 28% tax bracket. What happens in that scenario?

((1+(0.06-0.005)*(1-0.28))^30)/((1+0.06)^30) = 0.56

The government manages to confiscate 44% of the purchasing power due to negative real yields and the taxation of inflationary gains. Think it can't happen? In the grand (ponzi) scheme of things, real yields of -0.5% and inflation of 6% are nothing. It could get much worse (think the 1970s and World War II).

Our generation has never seen such a confluence of financial troubles with far-reaching consequences. The U.S. government’s dubious fiscal situation presents a whole slew of unfamiliar problems. And preparing your investment strategy for these pitfalls ahead of the storm is the wise course.

What good would come of sitting in 5-year TIPS if our economy is even worse off 5 years from now and real yields continue to die? What's the plan if 5-year TIPS are yielding -1% at that time and we're stuck in a stagflationary mess? What would be done with the proceeds? Reinvest? Capitulate? Panic into gold at any price? All of the above?

Say what you will about gold investors (I personally think gold is overvalued, compared to toilet paper and other basic necessities anyway), but at least many understand the importance of matching long-term investments with long-term problems (especially those who bought gold a decade ago and are still holding it).

Disclosure: I own short-term TIPS, long-term TIPS, and long-term I-Bonds as part of a relatively balanced long-term bond ladder. Right or wrong, other than some cash and a home, that's pretty much all I own. Call me bearish (and not just for the short-term).