Chicken Little Gone Crazy?

We know that Chicken Little is a coward. Now we seem to have proof that he has gone crazy. Not only does he own Treasury bonds yielding under 2%, he has recently purchased more. 

Matthew 19:24 says,  "It is easier for a camel to go through the eye of a needle than for someone who is rich to enter the kingdom of God." 

Similarly, it is easier to win the Powerball than it is to make money buying US Treasuries at current low rates. Has Chicken Little lost what remained of his terrified, cortisol-filled mind? 

The Deal on Offer from the US Government

What happens if you invest $10,000 in a 10-year Treasury Bond? The current yield on such a bond is 1.88%; This is among the lowest in history. 

When you buy the bond you give the US Treasury $10,000. Then every six months they give you $89 in interest (roughly 50 cents a day). The government promises to give you back your $10,000 in 2026! 

In return for $1,880 dollars in taxable interest over a decade, the bond buyer takes 3 big risks.

Bond Risk Number 1: Inflation 

What will you be able to buy for $10,000 in 2026? Let us consider, low, average, and high inflation rates. 

Inflation is a nightmare for bondholders

Low inflation: Two days ago, the Federal government announced that prices were 1% higher than a year ago. If prices go up by 1% a year between now and 2026, the Treasury bond will lose almost $1000 in purchasing value. 

Average inflation:  Federal Reserve Chair Janet Yellen is worried that the current 1% inflation rate is too low! Chair Yellen is aiming for 2% per year inflation, and she is willing to tolerate a few years of extra high inflation to get back up to 2%.  At 2% inflation, all of your interest gets eaten by inflation.  

I never tire of this video making fun of the Fed and its desire for inflation (click on image):

The Fed believes inflation is good

Higher inflation: Of course, it is possible for inflation to be much, much higher than 1% or 2%. 

High Inflation led President Ford to start his WIN campaign
When there is high inflation, the bond buyer pays a very high penalty (sometimes called an 'inflation tax').    

Inflation rate 1% 2% 5% 10%
Interest earned (TAXED) $1,880 $1,880 $1,880 $1,880
Inflation tax (no TAX deduction) $947 $1,797 $3,861 $6,145
gain (loss) $933 $83 ($1,981) ($4,265)

Risk #1 to a bond buyer is inflation. The bond investor pays taxes on the paltry interest obtained, and risks getting back dollars that can buy little. 

Bond Risk Number 2: Opportunity Cost

Even in a tough investment environment, how hard can it be to make more than 1.88%? there are thousands of stocks that pay more than 1.88% including Apple. Furthermore, if there is inflation, companies can increase prices and their dividends. Thus, dividends have some element of inflation protection. Isn't apple stock paying 2% a year in dividends, with inflation protection, a better deal than a Treasury bond paying 1.88%? 
Opportunity costs can be high

Risk #2 is that the bond buyer locks up the investment for ten years, and foregoes all the opportunities in between. 

Bond Risk Number 3: Default

The final risk is that the US government may not pay back the bondholder. This is currently hard to imagine, in part, because the US government can create as much money as it wants. Default, were it to occur, would have to a decision that default was preferable to printing more money. Most likely, default would occur in the midst of an inflationary crisis. 

Nassim Taleb and a Black Swan

While I believe a US government default is unlikely, I also believe it is more likely than most people believe. Nassim Taleb writes about extreme events, their importance, and our inability to understand them. (Click here for very violent movie clip that makes a similar point -- don't watch if you don't want to see blood and death. The burglar with the knife to the woman's throat witnesses what he thought could not happen.) 

Risk #3 is that the unthinkable can happen. The US could default. 

Summary: Bonds at 1.88% are stupid

Treasury bonds at under 2% per year, look to have a lot of risk, and very little reward. In some strange circumstances, the bonds may default, the value of the bonds may be inflated toward zero, and there seem to be many better investments. 

Buying bonds seems like a mistake

Chicken Little's "Logic" for Bond Buying

Why does Chicken Little own a stupid investment? If you were scared by the movie clip, be prepared to be even more scared. Take the following quiz: 

If you have a pension, however, you can skip the quiz and go have a fancy meal. The world divides into lucky/smart people with pensions, and the rest of us. Imagine yourself retiring with your pension at 62, collecting some significant fraction of salary forever, with inflation adjustment, and no risk of outliving your pension. Smile and dine luxuriously. 

Pensions are good

If you haven't gone off to eat a huge meal because you do not have a pension, calculate your retirement income. Take the amount of cash you will have at retirement and multiply by 1.88%. The average family has about $100,000 in assets at retirement -- this earns about $5/day. Can you live on $5 a day?

Retirees without pensions are in trouble

I recently discussed the sad state of retirement in the US with my Uber driver. He and his wife are mad at the Federal Reserve for punishing savers such as themselves with low interest rates. 

I asked how much time they spent worrying about surviving retirement financially, and he said, "probably too much." I replied, "that is not possible, if don't have health concerns to worry about, you should spend all your time worrying about money for retirement." 

Senior citizens may have to drive for Uber until they are 90

Most people cannot live off their savings at 1.88%. That means they either have to keep working, or take some desperate investment risk that may pay more than 1.88%, but also might go bankrupt. 

While 1.88% is terrible, the interest rate can go much lower. How can interest rates go lower you might ask. The media are filled with fears of exactly the opposite -- higher rates -- including:

1. Janet Yellen told us just this week to expect rising interest rates. 

When Janet Yellen was young, seniors could live on their savings

2. US government bond interest rates are historically low. 

However, rates can go lower, much lower, and perhaps all the way to zero. In fact, 10-year government bonds in Germany and Japan currently pay 0.21% and negative 0.10% per year respectively (that's right, in Japan they charge you for buying bonds -- and you wonder why their economy is slipping back into recession.) 

Japanese monetary policy is far worse than US policy

Chicken Little owns US Treasury bonds yielding 1.88% because:
a) Chicken Little is scared.
b) Chicken Little is stupid.
c) Chicken Little is scared and stupid.
d) all of the above.
e) none of the above.
f) I don't like multiple choice tests.  

My answer is (a). I buy Treasury bonds because even though rates are low, I am afraid they can go lower. I have no pension, and I have young kids. The probability of earning very little money on our savings is better than the possibility of earning no income if we end up at negative rates like Japan and much of Europe.

No comments :

Post a Comment