Friday, April 20, 2012

Expected Return of Capital

Click to enlarge.

I'm using the bond market's 20-year TIPS to nominal treasury spread to estimate the expected inflation rate. You cannot see the 20-year treasury in this particular chart because the 20-year TIPS exactly covers it up.

The EE Savings Bonds offered today are guaranteed to double in price in 20 years. You can see that in the chart.

The 2.28% inflation rate is not locked in stone. In other words, the bond market could be wrong and most likely is.

Here's what happens at 1%.

Click to enlarge.

Here's what happens at 5%.

Click to enlarge.

Here's what happens at 10%.

Click to enlarge.

I'm not predicting 10% inflation. I own inflation protected bonds as insurance. Similarly, I don't think my house will burn but I do have fire insurance.

Also note that owners of inflation protected bonds should not root for more inflation. The higher inflation goes, the less capital is protected (due to the taxation on the inflationary gains).

This post inspired by Troy who brought up return of capital in a recent comment.

Source Data:
Treasury Direct: I Savings Bonds Rates & Terms
Treasury Direct: EE Bonds Rates & Terms
US Treasury: Yield Curve


Stagflationary Mark said...

One better hope that this country's pension funds aren't counting on bond market returns to meet their 8% return goals, lol. Sigh.

Then again, what are they counting on?

I should mention that people who expect to earn 10% annually from equities during this century – envisioning that 2% of that will come from dividends and 8% from price appreciation – are implicitly forecasting a level of about 24,000,000 on the Dow by 2100. If your adviser talks to you about double-digit returns from equities, explain this math to him – not that it will faze him. Many helpers are apparently direct descendants of the queen in Alice in Wonderland, who said: “Why, sometimes I’ve believed as many as six impossible things before breakfast.” Beware the glib helper who fills your head with fantasies while he fills his pockets with fees. - Warren Buffett, Shareholder Letter (2007)

Mr Slippery said...

The government has rigged the game quite deviously. You even lose with inflation protected securities.

Gold is even worse, because the illusory inflation gains are taxed as collectibles at 28%, not as capital gains. The government really hates gold hoarders, except for their own central banks of course.

Stagflationary Mark said...

Mr Slippery,

And with gold, you really don't know what the price will be in the future.

It could be good. It could be bad.

In any event, that's uncertainty.

Troy said...

Something about all our pension funds turning to net sellers right when they're going to need those 8% returns has got me troubled.

So much so I want to GTFO back to Japan, LOL, but they have a similar problem with their net buyers of JGBs turning to sellers this decade.

Not really sure how all this is supposed to work.

My mom, being a pre-boomer, had pretty good timing with all of this.

Stagflationary Mark said...


Something about all our pension funds turning to net sellers right when they're going to need those 8% returns has got me troubled.

"You know we'll have a good time then."