Wednesday, February 12, 2014

Special Bonus Discussion Topic

We are supposed to talk about taxes this week, but I’m going to do everything I can to avoid it. I’ll even go so far as to give you a Special Bonus Discussion Topic, even though I generally try to stay on the taking side of bonuses. Here it is:

What is up (or down?) with the interest rates on bonds in the United States?

I am a self-certified non-expert on the matter, but after last week's blog, I just can’t stop thinking about this. Why would someone invest in a 10 year bond that returns just 2.64%? In a best case scenario where inflation remains below average, there is hardly any gain at all. For the 5 year bond at 1.65%, the investment stands to lose money after adjusting for inflation.

Having devoted my amateur thinking to this for at least a few minutes, it seems to me that there are really only two reasonable explanations for this:

A. People think there will not be any inflation (or even, that there will be deflation)

B. The bond market is in a bubble

Perhaps if I were an expert, I would be able to consider Option A. In that case, I would suggest that if we compare the rates between regular bonds and inflation-index bonds (“TIPS”), we can infer what the market thinks about inflation, like this:

5 Year
10 Year

The logic beyond this comparison is that the investor who buys the regular bond instead of the inflation protected bond thinks that inflation will be less than the difference between the interest rates. If he thought that inflation was greater than the difference, he would have bought the inflation protected bond and not bothered worrying about the risk of inflation at all.

This means that the market of investors believe that inflation in the next 5 years will average less than 1%, and no more than about 1.75% over the next 10 years. Inflation this low happened in 1953-1965. It is certainly possible that it could happen again; although since 2008, inflation has averaged 2%. In general, markets tend to return to the average, but you never know when exactly that will happen.

Another possibility in Option A is that we are headed for a period of “deflation” like what happened in the Great Depression. I have trouble even thinking about what this would mean. Maybe it’s because I always had trouble reciting the alphabet backward.

I’ve read what some of the experts say about deflation, and they are pretty sure that the U.S. Treasury will do everything it can, including “quantitative easing”, to “stave off” inflation. I think you should never trust anyone that uses the phrase “stave off”. However, in this case I will make an exception because “quantitative easing” sounds both pleasant and harsh at the same time, and I’ve always liked sweet and sour chicken.

The other possibility is Option B, which is simply that there is no logic to these interest rates and the bond market is in a bubble. For this to be the case, we would need to demonstrate that the two most important symptoms of a bubble are present. First, there would need to be someone who would claim there is a bubble while most people do not think so. Second, we should be able to make the case that “this time is different”.

I have singlehandedly accomplished the first criteria. (You’re welcome.) For the second, plenty of experts have commented about the unique market conditions that we are facing, but I am the only one to propose this baseless conjecture:

This time is different because of the aging baby boomers. As the population ages, we have more people than ever before who are rebalancing their portfolios to place more and more money into bonds. As this happens – and it will continue for a while as the baby boomers are just starting to retire – the bond prices will remain high (and yields low) like they are today.

I thought this conjecture was so compelling that I did everything I could to prove it. As it happens, the evidence points in the opposite direction, as money has actually been moving out of bond funds into stock funds in the past few years.

Maybe it’s a bubble or maybe this time is different. Either way, I simply can’t justify investing in bonds in the U.S. at these prices. In my U.S. accounts, all the money I have allocated for “bonds” is sitting in cash.

What say you, loyal readers?


  1. The bulk of the bond market in the United States is simple debt that is primarily owned by other countries. Primarily China and Japan in your example. Foreign governments are not investing, they are simply lending money for various political reasons and they need simple safety to preserve their capital. The bond market is not for individual investors...unless you don't want to gain any positive return. It is like a safety deposit box, the risk of losing the money you store there is very, very low.

    1. Foreign governments own about 30%, which is equal to the amount owned by investors. Check out this nice chart:

  2. I think Bitcoin has a better ROI.

    1. Than bonds? Definitely!

    2. Investing in BitCoin would be currency trading. I'll need to cover that under a special blog on alternative investments.

  3. Puerto Rico is a territory of the United States - does that qualify as US Bonds? It has a much higher ROI.

    1. The rates I quoted are for the federal U.S. bonds from the U.S. Treasury. The municipal bonds (like those from Puerto Rico, or U.S. state and local governments) are different. They are more like corporate bonds and will have higher yields according to the anticipated risk of default (i.e. credit rating). When I first looked at the yields in the U.S. a few months ago, I invested in corporate bonds for the higher yield, but I pulled the money out because this did not seem like a good idea once I thought about it some more. If you don't think the interest rates on the federal bond rates are not high enough, then unless you happen to think that the market has mis-priced the credit risk, you also by definition do not think the yields are high enough on municipal or corporate bonds.

    2. In general, the world finance markets consider the US treasury bond as the "efes" (0) risk benchmark.

      It is like hiding money under your sleeping mattress.

  4. Interesting news: Israeli economy at slowest growth rate since 2009.

  5. Waiting for your currency hedge recommendations...

  6. Last we discussed currency hedging ( the thinking was that it would be easier to just bring your money over and convert it to shekel. What do you think?

  7. It all depends on where the NIS stands...right now is not a good time to move your $$$ to NIS. When it goes back up to 3.8 or 3.9, definitely. When it drops down to 3.5 or 3.4, that is a great time to buy dollars. It is like a sine wave, it is always going up and down over time.

  8. The world generally considers US Treasuries as the risk-free rate. What might be happening is that people are willing to "pay" (i.e. lose principle) relative to inflation, for the protection of a risk-free asset. So, perhaps inflation is assumed higher than the Treasury rates but people are still OK buying Treasuries because of its safety.