Wednesday, November 9, 2011

The Power of Treasury Note Hindsight

Knowing all we know now about the deflationary events (two major stock market crashes and one major housing market crash) over the past decade which do you think would have been the better investment in 2001? Treasuries with inflation protection or treasuries without?

January 10, 2001
10-Year Inflation Protected Treasury Auction Results


January 10, 2001
10-Year Nominal Treasury Rate


January 2001 to January 2011

Expected average annual inflation rate: 1.578% (5.10% - 3.522%)
Actual average annual inflation rate: 2.319%

And the winner was... inflation protected treasuries (by a wide margin).

I guess long-term inflation has a way of creeping up on us, even during deflationary times. It also means that TIPS investors were actually paid to take the inflation insurance. Go figure.

That said, I am bracing for more deflation over the short-term and that mindset very nearly enticed me to alter my
inflation protected investments. As last seen in August, it's not the first time.

I've been giving some thought to locking in some profits on long-term TIPS but after thinking about these charts (the first two in particular) I'm content to hold them. Even today's 0.93% real rate on 30 year TIPS could look pretty good in hindsight if we experience 2 or more lost decades of real GDP growth. That's my theory and I'm sticking to it.

I thought long and hard about it again this morning. I even went so far as to place a sell order on the one long-term TIPS bond filling my IRA. Rates are down even more since I wrote that (prices are up). I placed the order an hour or so before the markets opened. I had a change of heart and cancelled the order though.

I think it is the first time in my life that I felt greedy for thinking about taking profits (as opposed to feeling greedy for not taking profits). We may get another round of deflation and part of me wants to sell that one bond now and buy that very same one back later. That felt greedy. I decided it was and instead opted to continue with my original plan to hold it to maturity.

Some would argue that moving to cash is the least greedy thing one can do. I'm not sure that is true. If one is moving to cash with anxious anticipation of a market crash while simultaneously having a plan to redeploy capital during the carnage then that would seem to be fairly greedy to me. In my opinion, that's market timing and casino mentality. I had it this morning. No doubt about it.

It eventually all came down to this for me. If I am still willing to buy 0.0% I-Bonds for the long-term (and I am) then I should be willing to hold a long-term TIPS bond of similar maturity within my IRA that has an even higher rate.

What an interesting day this has been.


Stagflationary Mark said...

As a side note, this is also the kind of thing that I considered today when trying to decide if I should keep my sell order. I found it virtually impossible to find out how much it would cost me to do the trade.

What You Don't Know About the Bond Market Can Hurt You

Brokers exploit the naiveté of investors in several ways. The first is through markups (when an investor buys a bond) and markdowns (when an investor sells a bond). It is very unfortunate that the SEC does not require a broker-dealer to disclose the amount of markup or markdown charged. The result is that transactions costs in bond trades can be like icebergs, where the largest part (seven-eighths) is hidden beneath the surface. Because glacier ice is only slightly lighter than an equal amount of seawater, most of an iceberg remains below the waves.

The less I trade bonds the better. You can see why I generally prefer to buy bonds directly from the government and hold them to maturity. Unfortunately, that's not possible within my IRA.

Ameritrade claims that they have "transparent" pricing. Read the following and see if you think that's true about bonds.

thinkorswim by TD Ameritrade

TD Ameritrade may act as principal on any fixed-income transaction. When acting as principal and receiving compensation on a net yield basis, we will add a markup to any purchase, and subtract a markdown from every sale. The markup or markdown will be included in the price and yield quoted to you.

The markup and markdown is included in the price and yield so I have very little idea what it actually is (which is exactly the way they like it). I have no way of knowing how much money they made off of me when I bought the bond back in February and I have no way of knowing how much they would make off of me if I resold it now.

Stagflationary Mark said...

From the first link...

In a May 2002 ruling, SEC administrative law Judge Lillian A. McEwen dismissed fraud charges brought by the SEC and the MSRB against a Los Angeles broker. McEwen concluded: “Markups and markdowns on municipal securities ranging from 1.87 to 5.64 percent were not excessive and did not violate the securities fraud laws.”

It makes me want to vomit when I think about that.

My version of the Occupy Wall Street movement is to buy TIPS and I-Bonds directly from the government and hold them to maturity. It's called cutting Wall Street out entirely.

My primary motivation was not to screw Wall Street (pardon my language) but rather to protect my nest egg. Over the last decade, it's been six of one and half a dozen of the other though, lol.

Mr Slippery said...


This has been an earth shaking day in many ways. The crash of Italian bonds, the firing of Jo-Pa, the BK of Jefferson County (largest muni BK in the history of the US). The USGS also says that water injection is causing earthquakes in Oklahoma. Literally earth shaking.

I relate to your struggle, but I often give in to the casino mentality. Our system is, after all, a casino. I won today, shorting the market at the open. But it is brutal to win long term. I have traded more this year and netted less. A lesson for me to learn.

At Vanguard, I can see the buy/sell spread on bonds. Sometimes they are small, sometimes large, it just depends on what brokers are hooked into their system at that time. Bonds are much less liquid than stocks, except Treasuries. I am not sure you can do any better next year so staying put was probably smart.

Also, if US bond rates soar next year, it means the whole global system is falling apart and we will have bigger fish to fry.

Stagflationary Mark said...

Mr Slippery,

But it is brutal to win long term.

It is brutal. I think of the brutality every time I see a commercial telling us about online trading tools. Clearly if we all use the same tools then we cannot each have an individual advantage. Further, the big boys use FAR better tools than we do. How's this for cynical? I think their tools look for weaknesses in our tools (especially ones based on common technical analysis).

Part of the reason I dislike trading so much is that I feel I'm armed with a club and my opponents (think Goldman Sachs) have financial weapons of mass destruction. The playing field is completely level during a treasury auction though. If a bond is good enough for the big boys (and they are the ones who set they yield in the auction), then they are also probably good enough for me.

I have to be pretty smart/lucky in order to make a trade. I just wish it was 100% smart and 0% luck. It's not even close. Any good casino tries to make us think that we are smarter than we really are.

Also, if US bond rates soar next year, it means the whole global system is falling apart and we will have bigger fish to fry.

We are agreed on this for sure. If bond rates soar as Jeremy Siegel predicts, then it won't be because of renewed American prosperity pulling investors into riskier assets. Instead, it seems far more likely that it would be because the safer assets weren't all that safe.

The massive rally in the stock market since 1980 wasn't enough to raise interest rates.

The near doubling of the stock market in the past few years wasn't enough to raise interest rates.

So what prosperous activity will?

Mr. Fusion? I somehow kind of doubt it, if for no other reason than it would cause the price of oil to crash. Would a crashing oil price would lead to higher interest rates? Doubt it!

No sir. About the only way I see interest rates rising significantly from here is through massive global financial pain and suffering.

Anonymous said...

Actually--you laughed about TPS some time ago, but did you ever think about buying a little to hedge your TIPS, instead of selling them??


Stagflationary Mark said...


"We need to talk about your TPS reports."

Sorry! Just had an Office Space flashback! ;)

In all seriousness, what would be my hedge?

I have no desire to be an options trader/gambler. At best it requires timing. At worst it is a zero-sum game that also feeds Wall Street's pockets through fees.

In a sense, I have the same mindset when it comes to any form of insurance. I prefer to only insure against catastrophic losses. I'm generally not interested in extended warranties.

I do not foresee catastrophic TIPS losses on 25+ year TIPS I hold to maturity. It could happen but the cost of insuring them for 25+ years would be its own form of catastrophic loss.

Further, an investment either has value to me or it doesn't. If it doesn't have enough value then I'd prefer to sell it and buy something else (or simply wait for a better opportunity). Can't say I always nail the value part but the plan's been working fairly well over the long-term, at least so far.

And lastly, a TIPS bond ladder is in some sense its own form of insurance. I want rates to rise so that when bonds mature I can reinvest the proceeds at higher rates. The bigger concern is that my TIPS do too well and interest rates fall. Fear of falling rates is why I allocated extra money to long-term TIPS back in February. Locking in that rate was a hedge/insurance. In hindsight, falling rates have not really made me better off. Not locking in the rates would have made me worse off though. I was either smart or lucky on that trade so far. I'll take either. Whew!

Anonymous said...

>>I do not foresee catastrophic TIPS losses on 25+ year TIPS I hold to maturity. It could happen but the cost of insuring them for 25+ years would be its own form of catastrophic loss.<<

I see--you were just having a casino moment the other day?? :)


Stagflationary Mark said...


I was absolutely having a casino moment. I recovered my sanity before the market opened though.

It was driven by greed but it took me about 30 minutes to figure it out. Locking in profits is generally a protection move. I wasn't looking to protect myself though. In theory, by holding to maturity I've already got that. I was looking to bet on Christmas deflation and jump back in on the same bond next year. Greed! I had no backup plan if I was wrong and stagflation appeared instead. What would I do? Sit in cash and watch inflation erode my IRA while waiting for higher real yields that may never come? I'm not saying that it would necessarily be a bad plan, but I don't need to be taking on that risk/stress.

I've been buying individual TIPS and I-Bonds for more than a decade and I've yet to sell or cash one out early (not counting a TIPS bond fund I also once owned). It was never part of my plan to do so. I value capital preservation first and foremost.

Anonymous said...

Well I appreciate the blog post--I'm sure you are not the only one thinking this way who is holding on to TIPS. Like LQD and HYG, TIP may experience a substantial fall in the next 12-18 months if we enter another recession--thanks.

TIP will most likely gain it all back, as we saw post 2008 crash.

Stagflationary Mark said...


The TIP message board is currently being overrun by one TIPS bull who thinks nothing bad can happen. That makes me uneasy. It was a trigger that made me want to lighten up.

On the other hand, here's what I wrote back in June on that message board. It is the same thing you suggest.

If you can tell me that things are about to pop yet again then I wouldn't want to sell my long-term TIPS. While there might be some short-term deflationary pain again, I think it would eventually be offset by even lower long-term real growth expectations.