Tag: bonds

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The I Bond Solution

I learned about a timely investment tool from an article by Burton Malkiel in the Wall Street Journal this past month.

Timely, because observed, economy-wide inflation has finally hit us and prompted the Federal Reserve to acknowledge that “transitory” isn’t the right word for inflation anymore.

inflation_in_2021

I don’t give investment advice here, nor should you ever take investment advice from a stranger who writes a blog or newspaper column. So this is not something you necessarily should do. Rather, I think it’s worth knowing about tools that may solve a particular worry of yours, particularly if it’s been nearly 40 years since we’ve actually experienced broad-based inflation.

Malkiel is best known as the author of one of my personal All Time Top Five Investing Books, A Random Walk Down Wall Street.

So for me – just like in those E.F. Hutton commercials that the over-50 crowd will remember – “when Burton Malkiel speaks, people listen.”

In his article, Malkiel introduced the US Treasury I bond as a tool that we should consider as part of their overall portfolio.

Here’s the part that makes I bonds quite sexy right now. Because the consumer price index jumped so much this Fall, the yield on I bonds is 7.12 percent. I bonds purchased in January 2022 will enjoy this fixed rate until July 1st. That is the highest interest rate that I bonds have offered since May 2000. The semi-annual yield reset will track the consumer price index in the future. After the next reset, the yield could very well go down, if inflation goes down. If it stays high, the I bond will keep a very nice yield, which is why it’s a plausible hedge against inflation. No matter what the inflation rate is in the future, the yield on I bonds can not go negative.

i_bond
U.S. Treasury Series I Savings Bonds.

Institutional investors – big funds and insurance companies and banks – typically have looked to TIPS (Treasury Inflation Protected Securities) when they worry about inflation. Since 1997, investors have been able to buy these bonds that pay a fixed interest but that adjust their principal upward in response to inflation, also as measured by the consumer price index. 

The little guy has typically only been able to access TIPS through mutual funds. Because inflation has been so tame since 1997, TIPS have rarely been high yielding, but instead have offered a hedge against the “what if” scenario. And that “what if” has hardly shown up until recently. Returns over the past 10 years on a TIPS fund have been in the 3 percent annual range, before taxes, with the biggest boost to that performance hitting in the past two years.

Unlike TIPS, you would buy I bonds directly online from the US Treasury, without a brokerage company or mutual fund. They’re not saleable by a brokerage, nor by you. You buy them in increments from $25 up to $10,000 maximum per social social number, per year. They register in your name only, or the name of the trust or partnership buying it. 

I bonds are designed for retail investors with a long time horizon, and do not work as well for a short-term trade. That’s because you will pay a 3-month interest penalty if you redeem after 1 year. Although they can’t be traded and are intended to be held for 30 years, you can redeem your I bond after 5 years without penalty.

ibond_details
A detailed comparison of TIPS and IBonds from the Treasury website

Because interest accrues until maturity or redemption, you will pay income tax on the interest only at the end. The following fact is irrelevant for Texans, but the interest earned on I bonds is exempt from local and state income taxes, like traditional municipal bonds.

Speaking of traditional bonds, US Treasury or corporate bonds are the last thing you want to buy in an inflationary environment. In addition, US Treasury bonds offer a measly 0.5 percent to 1.8 percent right now. Even a basket of high-risk corporate bonds (what we’ve impolitely called junk bonds since the 1980s) only get you about a 4.5 percent annual yield. That’s unacceptable unless you enjoy locking in losses against the current observed rate of inflation.

Maybe another concluding thought about this particular investment tool is in order. I, personally, will not be purchasing inflation bonds, neither TIPS nor US Treasury I bonds. I’m not actually that worried about inflation in my life or in the economy. I think my combination of real estate (my home!) and stocks (my retirement accounts!) will serve me fine under medium-level inflation. But I have a different risk appetite from most – my appetite is quite high. And I have a longish time horizon. I’m turning 50 this year so I have another 80 or so years to live (if my math is correct?) 

I’m not deviating from my plan (Buy 100% equity index funds, never sell) but I mention this I bond product so that you’re a more-informed investor. 

Also, you should read Burton Malkiel’s classic A Random Walk Down Wall Street. That is my strongest investment recommendation. I wouldn’t recommend any particular stock or bond to buy, but reading a classic like Malkiel’s book is highly likely to make you richer in the long run.

A version of this post ran in the San Antonio Express News and Houston Chronicle

Please see related posts:

Book Review: A Random Walk Down Wall Street by Burton Malkiel

Never Sell – A Disney and Churchill Mashup

How To Invest

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100 Year Bonds In The Trump Era

The United States does not currently issue bonds with maturities longer than 30 years, but the idea of super long-dated national debt is back in the air. Long-dated, as in bonds due in 100 years. One reason 100-year bonds are kind of neat is that nobody alive right now ever needs to worry about paying the principal back!

Setting snark to the side (for just a moment), Treasury Secretary Steve Mnuchin, in an interview in December, appeared open to the idea of 50-year or 100-year bonds, floated by financial newspaper Barron’s back in November 2016.

Barron’s followed up in February with the report that Mnuchin asked his staff at the Treasury department to look into the pros and cons of 100-year debt.

100yr_bondsSome of the best reasons for the United States to issue 100-year bonds fit reasonable, prudential, debt-management principles. Other reasons facilitate wackier scenarios. I’ll describe both.

But first, who would buy 100-year bonds from the United States? Buyers are not typically individuals like you and me, but rather institutions that have to make payouts far in the future.

Barbara Mckenna, Managing Principal of Longfellow Investment Management Co, a Boston-based firm managing over $9 billion in assets, noted to me last week that buyers of ultra long-dated bonds tend to be pension funds and life insurance companies, institutions which need assets to match their liabilities, stretching into the future for many decades.

These were the buyers for Austria’s 70-year debt issued in late 2016 at a rate of 1.53 percent. Ireland and Belgium both issued 100-year bonds earlier in 2016 presumably to that type of buyer as well, both reportedly with a 2.3 percent coupon.

“Feed the ducks while they’re quacking,” we’d often say in my old bond salesman days, when we issued new debt. There’s an element of that to justify the US issuing 100-year bonds. Right now, the pension funds and insurance company ducks would happily quack for extremely long-dated US Treasuries, so we might as well satisfy their hunger.

The three most legitimate reasons for the US to issue ultra long-term debt are:

  1. To ease “rollover” risk,
  2. To fund ourselves at historically low rates, saving money, and
  3. To facilitate long-dated corporate bond issuance

First, if your country issues mostly short-term debt, as ours does, the “rollover” problem happens constantly. If you have, on average, more long-term debt including for example 100-year bonds, you’ve gone some way toward relieving your rollover problem.

Next, the cost-savings from long-term low rates could be significant. A few numbers can help put this into context.

The federal government currently owes approximately $19 trillion to all creditors, and paid $433 billion in interest on its debt last year.

The federal government pays 2.26 percent on all of its debts, as of March 31, 2017, an extraordinary low rate.

15 year ago, the average interest rate on long-dated bonds was 8.27 percent.

10 years ago, the average interest rate on long-dated bonds was 7.55 percent.

Right now a 100-year bond – depending on a variety of factors such as the size of issuance and the demand from investors – could cost something like the current rate on 30-year bonds, or approximately 3 percent per year. McKenna agreed with me that a 100-year bond “probably would not be dramatically different from a 30year bond in terms of yield.” It might cost the US government a bit more, although it also might cost less.

bond_yieldsWhile a 3 percent 100-year bond would represent a higher rate than the US currently pays on average over all, locking in that rate for a long-time probably offers big interest cost savings over the long run.

We’ve got close to $2 trillion in long-dated bonds outstanding currently, due between 10 and 30 years from now. To point out some simple math (albeit simple math with a lot of zeros involved) a 1 percent drop in the average interest rate on a trillion dollars in long-dated bonds saves $10 billion per year in interest payments.

The third reason for 100 year bonds – and this reason appeals more to bond nerds like me, concerned with smooth-functioning capital markets – is that private corporations can issue more long-dated debt if there are long-dated US Treasury bonds to compare them to. Bond traders really like corporate bonds to match the length of government bonds, as it makes hedging and trading those corporate bonds much easier.

So 100-year US Treasury bonds aren’t crazy, could be issued affordably, and offer some capital market advantages.

Now, you’ve been patient with me and my bond math, so let’s get a little crazy. For readers interested in historical bond trivia – and yes, I’m talking to both of you – ultra long-dated bonds have interesting ties to global catastrophes.

England issued perpetual bonds to finance itself during the Napoleonic Wars, and 100-year debt to finance itself during World War One.

I think of this global catastrophe and 100-year bonds because a time may indeed come in the medium-term future when we have trouble rolling over our debts.

trump_pointingIf we were in a shooting war with China – or even just a nasty trade war – for example, we might have trouble with the fact that Chinese institutions own approximately $1 trillion of US sovereign debt. Heck, if we get into a shooting war with North Korea this week or next week we might face rollover trouble, as a signal from Chinese institutions displeased with our unilateral military actions.

Fortunately, our current President has deep experience with the inability to roll over debts. He ran his casinos into the ground this way. Given his experience, he stated his plans for federal debt issuance while still a candidate, just last summer.

“I’ve borrowed knowing that you can pay back with discounts. I would borrow knowing that if the economy crashed, you could make a deal.”

Oh, sweet mercy, please, no. But then a few days later candidate Trump clarified, default isn’t really necessary. “People said I want to go and buy debt and default on debt. I mean, these people are crazy. This is the United States government.”

I was starting to feel better.

But then he continued,

“First of all, you never have to default because you print the money, I hate to tell you, okay, so there’s never a default.”

Ah, yes. Thank you Mr. President for clarifying your views on sovereign debt.

Dear Treasury Secretary Mnuchin: Can we please issue massive amounts of 100-year bonds quickly before anyone re-reads these quotes and thinks about them too closely?

 

 

A version of this post ran in the San Antonio Express News and the Houston Chronicle.

Please see related posts:

 

Trump and the coming Financial Crisis

Trump: Sovereign Debt Genius

Book Review: The Making of Donald Trump by David Cay Johnston

 

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Trump Wins. Markets Panic. Why?

trump_victoryStock markets worldwide will drop significantly tomorrow, and throughout the rest of the week, as US and global investors recalibrate their expectations of the United States due to the little-anticipated Donald Trump victory in today’s Presidential election.

Stock Market

From an individual investor perspective, I suddenly have deep regrets about two pieces of 100% rock-solid advice I’ve given out about personal investing in the stock market. The first is that there’s no particular advantage to owning ETFs over mutual funds, since nobody should really need to trade their personal stock holdings in the middle of the day. ETFs allow you to trade at any time when markets are open, whereas mutual fund investors can only trade based on the day’s closing price. But I’ve never believed any individual investor should be in a such a hurry to sell that a mid-day trade is better than an end-of-day trade.

With the victory of Donald Trump, I’m really sad that I have to wait until the end of tomorrow to sell stocks, rather than mid-day.

Implicit in this comment is my second deep regret. My advice has always been the Winston Churchillian rock-solid “Never, never, never never sell.”

But of course now I want to. It will take all my will-power to do nothing, as I watch stock market values plunge tomorrow.

******

tracy_chapman

In a seemingly unrelated vein, (but is it?) my favorite Tracy Chapman song “Why” goes like this:

“Why do the babies starve when there’s enough food to feed the world?

Why are the missiles called Peacekeepers, when they’re aimed to kill?

Why is a woman still not safe, when she’s in her home?

Love is Hate. War is Peace. No is Yes. We’re all free.”

No Gridlock

It’s both a cliche and a truism that Wall Street prefers gridlock in Washington. Gridlock is predictable. Gridlock is  stable. It prevents wild swings in policy. A divided Executive and Legislative branch tempers drastic or rapid change in regulations.

With a newly elected and strongly Republican House and Senate, and Donald Trump appearing to have a “mandate” for his bat-shit crazy ideas, whims, and personal vendettas, who is going to be the check and balance on the worst ideas from that side of the aisle? Like Trump’s fiscal spending plan, for example, estimated by a bipartisan budget group to add $5 Trillion to the federal deficit? Like Trump’s continual threats to unilaterally alter trade agreements or punish our most important trading partners like Mexico and China?

******

Tracy Chapman continues singing in my head:

“But somebody’s gonna have to answer

The time is coming soon

When the blind remove their blinders

And the speechless speak the truth.”

******

US Treasurys 

US Treasury bonds typically live in what the kids on the show Stranger Things would call The Upside Down. Meaning, if stocks go down, bonds go up. When stocks go up, bonds can go either sideways or down. And that’s what’s happening with a Trump victory tonight. A huge bond rally is happening right now, overnight, as I type this at midnight on Election night.

upside_down

But also, this rally in US Treasury is a totally bonkers reaction to a Trump victory, since Trump actually threatened to renegotiate US sovereign debts, if need be. No responsible financial or political US leader has ever made that threat. We’ve never defaulted, or threatened to default. Alexander Hamilton’s lasting contribution1 to our country’s strength is our rock solid credit, ever since 1789. Threatening US Treasury default is the kind of Third-World bush-league bullshit disruption that bond people don’t appreciate, and which I wrote last summer would have unknowable but possibly catastrophic consequences for our country, which actually is heavily indebted but treated like a safe bet in world markets. Until now.

Back to you, Tracy:

“But somebody’s gonna have to answer

The time is coming soon

Amidst all these questions and contradictions

There’re some who seek the truth.

Love is Hate

War is Peace

No is Yes

We’re all Free.”

Why?

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  1. Outside of inspiring Ron Chernow and Lin-Manuel Miranda’s book and show, respectively ↩
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NIRP

NIRPWhat is the key signal, for you, that we’ve arrived at End Times? Maybe war and famine? The sun turning black and the moon turning blood red? That other party’s Presidential candidate – the one you hate – might just be the Antichrist? Sure, sure, all very scary.

I’m a finance guy, so I’d argue: maybe negative interest rates?

The fact that trillions of dollars worth of European and Japanese debt, right now, is at a negative rate is possibly a sign of the Apocalypse. At the least it violates a clear 5,000-year-old rule: Interest rates must be positive.

Under a negative interest rate policy – snappily acronymed as NIRP and pronounced like “nerd” with a “p” at the end – banks in Europe actually have to pay the European Central Bank to hold their money. The same is true for short-term loans at the Bank of Japan, although the BOJ just announced 10-year bond rates may rise to 0 percent, aka ZIRP.

This makes 2016 a highly anomalous break with financial tradition, on a biblical scale.

Time Value of Money

Finance theory posits that money in your hand today is worth more than money in the future. We finance nerds call this the ‘time value of money’ rule. If I agree to lend you money today, you need to give me back more money in the future as compensation.

The extra money you pay me in the future, the interest, also partly accounts for the risks that:

  1. You wont pay me back in full and at the agreed time, and
  2. The depreciating rate of the value of money – what we call inflation – won’t be bigger than we expected, by the time my money gets returned to me.

We’ve always known this is just the way the world works, and this concept of time value of money, and a positive interest rate, was a totally unbreakable finance rule. Except now, in 2016! Seriously, what is happening here, people?

Now I’ll tone down the apocalyptic goofiness and argue with myself – in front of you! And for your benefit! – that in fact maybe there’s a plausible normalcy to this whole thing?

Usually loans and bonds work like this: I give you my $1,000, and at the end of the time period you pay me back my $1,000, plus some percentage extra. A 5% annual interest rate loan or bond pays me $50 interest per year, plus return of my original $1,000.

Under a negative interest rate policy when a bank stores its $1,000 of money with a Central Bank, the bank could expect to receive back – with for example a negative annual 0.25% rate – just $997.50, after one year.

use_it_or_lose_it

This sounds ominously like a central bank is taking the private bank’s money and we shouldn’t be surprised when a NIRP increases the already considerable paranoia about the evils of central banks, quasi-governmental entities like the Federal Reserve that set monetary policy for a country. But they’re not really trying to steal money. The policy goal, from the central bank’s perspective, is to encourage holders of excess money – like banks – to spend that money on investments rather than hoard their cash.

When it comes to cash, “Use It Or Lose It!” shouts the NIRP, in the voice of your least favorite gym teacher.

With a bond offering a negative interest rate, like Germany’s 2-year bond as of this writing, you’d pay the equivalent of about $1,010 to buy the bond, receive no interest for two years, and then get your $1,000 back at the end. Hey Germany! Thanks for less than nothing, buddy!

Negative yields on bonds actually started popping up near the end of 2015. The big change this year is that bond buyers in large parts of Europe and Japan have willingly signed up for negative interest rates from the get-go. That makes financial sense only if the bond buyer expects the opposite of inflation, meaning deflation. If I expect the prices of most things to go down over the next few years, I guess I’d be willing to exchange my $1,000 today for $997.50 in the future. As long as everything’s cheaper in the future, I suppose I’m cool with less money.

Accepting negative yields also makes sense if I absolutely, positively, cannot find any reasonable riskless place to park my excess cash, which seems to be the other major problem for Japanese and European holders of excess money.

You might think, logically, that just holding your money in cash for a year would be better than one of those German or Japanese bonds, and that’s a reasonable thought. But large holders of excess money find cash eventually becomes cumbersome. Physical cash works better on a small scale than a large scale.

The size of NIRP

Speaking of large scale, how big is the negative interest rate world in 2016? It’s become a common central bank policy as well as prevalent in major (for now, non-US) bond markets.

In Japan, beginning in January 2016, the Bank of Japan declared that certain bank deposits would receive a negative 0.1 percent rate.

Switzerland, through the Swiss National Bank currently pays negative 0.75 percent on deposits, and sets a range on inter-bank lending at between negative 0.25 and negative 1.25 percent.

As of this writing, major benchmark bonds in Germany, Spain, Belgium, Netherlands, Sweden, and Italy all offer negative yields to investors.

By mid-September, the Wall Street Journal reported, debts with a negative interest rate totaled $8.3 trillion worldwide, the majority from Japan, and down from a peak amount in July of $10 Trillion.

 

We don’t know yet – in September 2016 – whether negative interest rates will become an odd trivia answer about this weird year, or whether they become an ordinary feature of global finance in the future.

One reason to think NIRP becomes normal-ish is that some economists have both anticipated and encouraged negative interest rates, as monetary policy, to encourage growth.

Harvard professor Kenneth Rogoff recently published a book The Curse of Cash in which he argues that negative interest rates can be, and should be, a normal tool of central banks. He’s updating the debate in real time, alongside our shifting finance reality. Controversially, to prevent physical cash hoarding. Rogoff also advocates in his book the phasing out of large-denomination bills, like $100 bills or more. NIRP works better – from an economist’s perspective – if people don’t have the chance to stuff large amounts of bills in their proverbial mattress.

Let’s make money

Meanwhile, I feel like there are a lot of people reading this who would like to borrow a lot of money at zero interest rate, and who would promise to be really careful with it.

I think all you need to do is know some Japanese banks, promise to hold their Yen safely at zero interest for a year or more, and do it for, like, many billions of dollars worth of Yen. Your zero percent offer to borrow should be so exciting for Japanese banks, as they can’t get that kind of great deal in their own country. After you arrange this multi-billion dollar deal, be sure to offer a generous referral fee to your favorite financial columnist.

If it’s End Times, I want to go out rich!

A version of this appeared in the San Antonio Express News and the Houston Chronicle.

 

Please see related posts:

Video – Time Value of Money

One Rate To Rule Them All – Federal Reserve Explainer

 

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Pundits Talking Their Book

One of clearest, most knowledgeable, and most readable pundits on financial markets is a guy named Bill Gross. Gross, known in financial circles as the “The Bond King” and the founder of mutual fund giant PIMCO, writes an entertaining monthly letter with musings on his life, asset prices and value, and the future direction of financial markets.

Despite the nice things I just wrote about Gross, you should never, ever, take his advice when it comes to investing. Ever. The man’s monthly newsletters are the most egregious example of what’s known in finance as “Talking your book.”

“Talking your book” means telling other people how they should trade based on what would benefit your own financial portfolio and positions.
In Gross’ case, every single newsletter he’s written for the past twenty years concludes with an exhortation or justification to buy bonds. Which is pretty coincidental, considering he built the world’s largest bond fund.

Great salesman. Not a great predictor of the future
Great salesman. Not a great predictor of the future

As a salesman, he’s phenomenal.
As a reliable ‘expert’ on financial markets whose advice should be acted upon? He’s a total catastrophe.

Ordinary course of business
Back in my Wall Street days, people talked their book as a matter of course. It was literally my job to explain to clients why the bonds held on my firm’s books were the ones they should buy, or why clients should position themselves with securities the same way we were positioned. That way, I attempted to create demand for the things my firm already owned so we could sell them. Or conversely, if necessary, talking our book allowed us to turn our risks into their risks. Much of Wall Street works this way.

My clients were extremely sophisticated investors and traders, and I don’t feel bad about this at all. They generally talked their books back to me in the hope I would have the same effect on my firm’s investment decisions. We all got very good at recognizing who was talking their book, and, overall all’s fair in love and war and bond sales. Not a big deal.

After I left Wall Street though, I noticed not everybody knew that nearly all finance experts talk their book, nearly all the time.

Knowing this can help in other situations as well.

South Texas
A friend of mine works in the oil and gas industry, delivering trainloads of sand across the country to fracking sites in South Texas. For the past six months, everybody in the fracking industry – from the drillers to the truckers to the hoteliers to the logistics companies – has been cutting back, idling workers and equipment, hoping to ride out the decline in oil prices.

My friend’s company delivers a fraction of the volume of sand that they used to deliver, a year ago.

He described to me how everybody in his world spends a lot of time obsessing over the future price of “the barrel,” which generally means the commodity price of WTI, which stands for West Texas Intermediate Crude. If WTI (aka ‘the barrel’) recovers six to twelve months from now they know all will be well for them and the industry survivors will reap huge profits. If “the barrel” stays low longer than that, however, many companies and people will be wiped out.

In that environment, with everybody’s business so exposed like that, few people can speak objectively about the “the barrel.” Everybody is left ‘talking their book.’

My friend says everybody’s got a theory about when and how prices will soon rise. Maybe geopolitical trouble with Iran will heat up again, hopefully? Maybe the Saudis will stop flooding the market with their crude to punish non-OPEC producers? A particularly hot summer is sure to boost energy demand and sop up the excess supply in the market, right? I mean, surely the new storage tank capacity in Oklahoma will allow us to ride out this oil glut, no? Maybe the US Government will stop dumping oil into the market to punish the Russians for their Ukraine aggression? (That last one is apparently a widely held theory to explain the drop in oil prices, which I find absurd.)

Every expert speaking on a panel to the oil and gas industry, or to a journalist covering the industry, has a theory on when prices will rise. Please give us some good news, the oil and gas industry folks all seem to be saying to each other.

Here’s the problem, though. They are all talking their book. Their views are not to be trusted at all.

Either consciously or unconsciously, people talking their book are particularly unreliable experts on the future of financial markets.

Experts in finance “talking their book” may simply be clever salesmen, like Bond King Bill Gross. Or they may be anxious and exposed to markets, like the entire oil and gas industry in South Texas.

People talking their book generally only mention out loud the data that support their position. The counter view of the market, “the other side of the trade,” generally goes wholly unmentioned.

Here’s some advice you can use. You should always assume that any industry expert you see on television, in print, or online is talking their book. They didn’t go on TV to give you all sides of the story, but rather the data that supports their book of business.

How can you find people in finance who are not talking their book?

uncertainty

Look for the ones who admit to uncertainty. Seek out the experts who tell you what they don’t know, what cannot be predicted, and how opaque the future really is.
When they present data to support both sides of the market – why bonds may be good or bad, or why WTI could go up or down depending on a complex interaction between a series of unknowable, contingent, events – now you may be listening to someone not talking his book. Now you may be hearing from a real expert.

Keep looking for this.

 

A version of this appeared in the San Antonio Express News.

 

 

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