Government spending and the Fed’s policy of buying more long-term bonds, never mind how they pay for it, has pushed the U.S. Treasury yields to lows not seen since the 1940’s. This is significant because your conservative, “safe” money like T-bills, Treasury Bonds and even your CD’s are now subject to a certain type of risk: Purchasing power erosion, or inflation risk.
Bonds have 3 sources of risk: 1) Credit Risk – The risk of not getting paid back; 2) Duration Risk – the risk that rising interest rates will decrease the value of your bond because other bonds will pay higher yields. 3) Inflation Risk – The risk that the dividends you may get today will not buy as much groceries or gas in the future because of inflation. Along with these risk definitions, I also want to explain two terms used when discussing interest rates: The Nominal Return – the interest rate on the face of the bond or you see advertised on a bank CD for example; and The Real Return – the return you get after subtracting inflation.
Today, bond holders must deal with this purchasing power erosion. The Federal Reserve policies are keeping nominal rates below the rate of inflation. They’ve done this to keep financing costs low on Uncle Sam’s out of control spending. The result of this effectively shifts the burden of government spending onto you. How? Because the nominal 2% nominal return on 10-year Treasury bonds is below the 2.9% rate of inflation. Therefore, the real return on your bonds is -.9% and will continue to erode because it doesn’t keep pace with inflation. Even worse, calculate the real return on your CD.
We can look at the 1940’s as an excellent example of bond investing because it mirrors today’s environment with roughly the same nominal yields on Treasuries and Government spending greater than 100% of our Gross Domestic Product (GDP). If you invested $100,000 in 10-year Treasury bonds in 1941 to and redeemed your bond in 1951, you got your original $100,000 back, but in real return dollars, you lost $34,000 to inflation.
Some ideas for you to consider if you have heavy bond exposure:
First look to diversify within the bond asset class. This means look beyond U.S. Treasuries and AA rated U.S. Companies to foreign bonds, higher yielding corporate bonds. Also, you can diversify outside of bonds all together and research lower volatility stocks.
Second, refresh yourself on the definition of safety. What most people, especially retirees are looking for when investing in bonds is income. While continuing to hold CD’s and Treasuries with low nominal yields may serve one definition of safety, continued erosion of your purchasing power by inflation needs thoughtful consideration. Holding Treasuries and CD’s guarantee the return of your money, the cost of a good night’s sleep does come at a price. Like most things in life, there’s no such thing as a free lunch, unless of course you’re in the Senate or Congress.