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Let's say we want to invest in TIPS for 30 years and would like to maximize our risk adjusted return.
US Treasury: Yield Curve
5 Year: -0.82%
7 Year: -0.44%
10 Year: 0.07%
20 Year: 0.72%
30 Year: 1.07%
Let's assume a fairly modest long-term inflation rate (so it can be safely ignored from the calculations), shoot for a real return of 1.07% (not counting taxes), and do some back of the envelope math. It's not perfect but it is better than nothing.
I present 5 options that are roughly equivalent.
Option 1
Buy the 30-Year TIPS. Lock in 1.07%. Done deal.
1.0107^30 = 1.376
Option 2
Buy the 20-Year TIPS. Earn 0.72% for 20 years and earn 1.78% for the following 10 years.
(1.0072^20)*(1.0178^10) = 1.377
Option 3
Buy the 10-Year TIPS. Earn 0.07% for 10 years and earn 1.58% for the following 20 years.
(1.0007^10)*(1.0158^20) = 1.378
Option 4
Buy the 7-Year TIPS. Earn -0.44% for 7 years and earn 1.54% for the following 23 years.
(0.9956^7)*(1.0154^23) = 1.378
Option 5
Buy the 5-Year TIPS. Earn -0.82% for 5 years and earn 1.46% for the following 25 years.
(0.9918^5)*(1.0146^25) = 1.379
So the real question becomes...
Is it better to lock in today's rate of 1.07% or is it better to hope that making money off of money will become easier in the future?
I think it is a tough call. I very much think the bond market is struggling with that question right now, as am I. On the one hand, 1.07% is pretty low. On the other hand, so are my predictions of real long-term GDP growth.
This is the reason why I continue to hold 30 year TIPS even as their prices have risen. I'm not convinced that it will become easier to make money off of money in the future. That's the whole premise of my blog.
Could rates spike higher and present opportunities even if I am right to think this way? Absolutely. Do I wish to bet on that outcome? Not exactly. I have a bird in the hand mindset.
That said, I am sitting on more cash than normal. I'd certainly be willing to put some of it back to work if an opportunity appeared. I won't hold my breath though.
Friday: No Major Economic Releases
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[image: Mortgage Rates] Note: Mortgage rates are from MortgageNewsDaily.com
and are for top tier scenarios.
Friday:
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12 comments:
No jobs added in August.
Seems simple to me. Short the 5's, Buy the 10's, double your profits. You're not really worried about hyperinflation are you?
And if you're serious about stagnation, sell the 5's, buy the 30's, rinse for 5 yrs & repeat. No?
AllanF,
Seems simple to me. Short the 5's, Buy the 10's, double your profits. You're not really worried about hyperinflation are you?
And if you're serious about stagnation, sell the 5's, buy the 30's, rinse for 5 yrs & repeat. No?
What if the entire yield curve stays where it is and/or simply continues to fall together? In that situation I'd be better off just holding onto the 30's like I have been.
And no, I'm not trying to protect myself from hyperinflation. I think there are vast deflationary forces in this world to counter it.
I don't follow. Why care what the yield curve does? You said you have cash to invest:
cash: $500,000
short: $400,000 5 yr TIPS
long: $900,000 30 yr TIPS
Holding to maturity you are guaranteed capital gain on the 5 yr TIPS and in the mean time your income stream is exactly the same as if you'd bought $500,000 of the 30's, yes?
Or all the same, holding the 30yr TIPS you already have, buy more:
existing 30 TIPS: $1,000,000
short 5 yr TIPS: $ 800,000
long addt'l 30's: $ 800,000
One of us seems confused. Could well be me!
I am not looking to use leverage to boost my returns. I've been doing all I can to avoid leverage since I turned bearish.
Let me stick with your example.
If I short the 5-year TIPS to maturity then at the end of the 5 years the person on the other end of the trade will want all $400,000 of his money back plus inflation (minus a small amount due to the negative real yield). I'll also making very tiny interest payments to him along the way (very tiny, no big deal).
In order to pay the $400,000 plus inflation I will be forced to sell some of the $900,000 in 30 year TIPS I own.
What if I am wrong about where 30 year TIPS rates go? What if they've shot up to 4% or more? The current price of those $900,000 TIPS bonds could be as low as $400,000. No joke. There's a lot of interest rate risk on 30 year investments.
So in order to pay the person the $400,000 I owe him (plus inflation) I might have to sell all of my 30 year TIPS bonds just to cover it.
That would leave me with nothing. I'd be wiped out. Ouch.
Leverage works both ways. I prefer safety.
Here's something else to think about.
I have 30 year TIPS and I should be able to hold them all until maturity. It is not guaranteed though.
If inflation shoots up to 20% or more and is persistent, then I'll be forced to sell some TIPS just to pay the taxes (and I am forced into a higher tax bracket too). Scary. That alone is ample risk for me. I'm not looking to add any more. Sigh.
Hmm, this probably doesn't apply to "retail" traders but aren't Treasuries marginable at 100%? Or maybe it doesn't apply to TIPS?
But if you could, in 5 years even with the 30's trading below par, you can still use them as collateral to sell another slug of 5 yr TIPS to pay for the first slug coming due. You might get yourself a settlement violation with your broker, but once every 5 years is no big deal.
Of course, yes, the taxes on hyper-inflationary gains could wipe you out, but I thought you were serious about this whole deflation/stagnation thing. ;-)
1% return?
How about opening a business?
http://www.raceroom.net/
fascinates me.
The next generation of dual-socket LGA-2011 3D-transistor 32-lane PCI 3.0 motherboards are going to be mind-blowing.
Pop in 4 DX 11 video cards with 6 EyeFinity outputs each, one box can drive 8 stations with 3 1080P displays each.
Get a hardware audio mixer via firewire to handle 2.1 sound to each station, you'd have one helluva attraction for about $20,000 per box, $1250/station.
3 boxes, 24 stations would be $60,000.
1.5x staffing @ $15 would be $80,000 per year.
Lease and stuff would bring the investment to $200,000 the first year.
Need about $6/hr per station for 25 hrs/week, 52 weeks a year to break even.
Hmm.
In a previous life I worked for Virtuality UK, and they couldn't get these numbers to work in the 1990s either.
But the hardware is so much better now!
In the 1980s I had the luck to work in UCLA's on-campus arcade.
PRIMO location as far as street retail went. 30,000 young adults with time to kill and money to blow.
We had 100 machines and from 11 - 3 we had close to 100% utilization @ 5 minutes max per play, $300/hr gross.
Monthly collections were $60 - $100k.
Capital investment was $10 - $20k per month refreshing the inventory.
Staffing was $4000.
LOL.
They've got some lame-ass thing going now:
http://www.asucla.ucla.edu/proser_ser.asp?ref=gameon
but the magic days are over.
AllanF,
Of course, yes, the taxes on hyper-inflationary gains could wipe you out, but I thought you were serious about this whole deflation/stagnation thing. ;-)
I am similarly serious about my home. Although I am fairly convinced that it will not burn in my lifetime I still buy fire insurance every month. Can't explain it. ;)
Troy,
...but the magic days are over.
That's my biggest concern in 6 words or less, lol. Sigh.
Speaking of the magic days being over and UK gaming in general, I heard this on the radio today.
Paintball bursts British woman's breast implant
After the incident, UK Paintball added a statement to its website: "We respectfully ask that any ladies with surgical breast implants notify our team at the time of booking. You will be given special information on the dangers of paintballing with enhanced boobs and asked to sign a disclaimer."
D'oh!
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