Amit: ‘On May 4, you suggest TIPS, PCL and TRF as potential investments. Does this mean it is time to get out of ILA, CMM, SYM, TXCO? It was not clear to me what is your current recommendation for these securities.’
☞ No, I am holding all of those. If I do think it’s time to sell something, I will always note that here . . . unless I forget that I suggested it, which is always possible. But two things are very important to stress: The first – painfully obvious – is that if I were really good at this, I wouldn’t have to write this column. In other words, my suggestions are just that, suggestions, and one of these days, if not sooner, there are bound to be some big disappointments. Which leads me to the second thing to say, which is that in a bad market, almost everything goes out with the tide, even if, eventually, some of it may come rushing back. I worry that we may be in for a bad market. So the third thing to say – and already we are into extra-innings – is that under no circumstances should you be investing in the market with borrowed money (either on margin, directly from your broker, or indirectly, because you have credit card debt outstanding or any other high-interest debt). Indeed, I think this is a good time to keep at least some of your money safely on the sidelines, in case true bargains should come along.
One reason for my caution is the possibility of rising interest rates caused by inflation – or the fear of inflation.
Market sage James Grant, in his April 23 market letter, draws parallels to 1964, when inflation was under 2% and the Treasury’s long-bond was yielding 4%-and-a-fraction (it would sink all the way through 1982, as the yield rose to 15%). He wonders whether Baghdad in 2003 may not have been, to the financial road ahead, what the Gulf of Tonkin was in August 1964.
There are differences of course; for one, the Iraq war is thus far significantly less costly than was the war in Viet Nam, and will almost surely remain so.
But both are examples of ‘guns and butter,’ a combination that often leads to inflation. And that leads to TIPS – Treasury Inflation Protected Securities.
When last we left TIPS (of which more in a minute), I offered extra credit for anyone who could identify the movie ‘from whence’ the line ‘Get it? Got it? Good’ comes.
Michael Gonsior: ‘The meaning of ‘whence’ is ‘from where.’ So when you write ‘from whence it came’ – as you did – you are really writing ‘from from where.’ Don’t feel bad – most folks make this mistake.’
☞ Thank you!
Rob Sartain (and many others): ‘The line comes from The Court Jester (Paramount 1956), right? Oh, I’m smilin’ thinkin’ about Danny Kaye trying to determine if the pellet with the poison is in the vessel with the pestle, or if the chalace from the palace holds the brew that is true.’
☞ Avoid the flagon with the dragon.
Tom Ciullo: ‘That line, spoken by James Cagney, is from the 1961 Billy Wilder comedy One, Two, Three.’
☞ An homage, perhaps?
Charles Wright: ‘What about purchasing TIPS through a mutual fund (in a tax sheltered account)? Assuming that all interest earned goes into purchasing more TIPS that are added to the account – does this make any sense versus purchasing the individual TIPS?’
☞ The only downside I can see is the annual fee you pay. But if this is for your tax-sheltered retirement account, why not go for the long-maturity TIPS? Well, John offers one reason . . .
John: ‘Do mutual funds like Fidelity’s Inflation Protected Bond Fund (FINPX) and Vanguard’s similar fund (VIPSX) have the same advantages as TIPS? Is this a good place to put 401K and IRA dollars given the expectations by many for the return of inflation and higher interest rates? I ask because most 401Ks don’t allow you to buy TIPS.’
☞ Those funds are fine.
Chris: ‘It’s probably not a question of if the fed raises interest rates, in my mind it’s when. Will they do it before the election? Every time Greenspan speaks, it has been wreaking havoc with my portfolio. My TIPS are down about to where I bought them a few months back. I was looking at buying more, but I don’t know the effect that the eventual interest rate hike will have on them. Will they remain neutral in relation to that? I know a regular long-term bond would get killed.’
☞ Yes, as interest rates rise, the value of long-term bonds falls – always, absolutely. If the general level of long term interest rates rises to 6%, no one is going to pay you 100 cents on the dollar for your 5% bond. But TIPS are different. The return they pay sits on top of inflation. There is no reason they have to fall in price as inflation pushes interest rates up . . . because inflation will boost their value and pay-out as well.
Only time will tell, but the demand for TIPS could actually increase if inflation expectations come roaring back, as people look for some reasonable way to stay ahead of it.
A thing is worth only what people are willing to pay – $104 million, last week, in the case of a pretty painting of a boy with a pipe (just for the record, that was not me who bought it) – but my own sense is that the TIPS market has been a little illogical. The shorter-maturity TIPS have been priced to yield less than the longer-maturity TIPS.
For example, the bonds maturing five years from now, on January 15, 2009, closed Friday at a price that worked out to a 1.4% ‘yield to maturity,’ while the bonds maturing 10 years from now were yielding 2.2% and the bonds maturing 28 years from now (the ones I own) were yielding 2.5%.
Granted, there’s not a huge difference there. And granted, they ALL may be a little high – typically, one might hope for a yield more like 3% above inflation. These bonds would have to fall in price before their yield reached that level.
But here’s my point. Yes, with normal bonds, the longer the maturity, the higher the yield you normally expect – the higher yield is how the market induces you to take the extra risk. But with TIPS, what extra risk is there? The Treasury is unlikely to default; and the inflation risk is avoided. So might it not make sense for the longer maturity bonds to command a premium?
That is, might sensible investors not being will to accept a slightly lower yield on the longer-term bonds than on the shorter-term bonds? I ask, because to me, the extraordinarily attractive thing about TIPS is their guarantee to outstrip inflation. That being the case, which is more extraordinary: A bond that guarantees to outstrip inflation for the next five years? Or one that guarantees to outstrip it for the next 30?
I suppose there could be some reasons to buy the shorter term TIPS, even though you get less of a guarantee and less of a return. But in most scenarios, I think I’d go for the combination of greater guarantee and higher return.
This is just my opinion, and I did not go to MIT. (I have passed it many times – in the sort of awe one reserves for the kids who could actually do the quadratic equations.) Some of you know more about this than I, and we will all welcome your thoughts. But however overpriced TIPS may still be, yielding less than my rule-of-thumb 3% above inflation, it seems to me that the long-term TIPS, yielding 2.5% above inflation are relatively more interesting than the 5-year TIPS yielding 1.4% above inflation.
The last thing to say about this, if any of you are still reading (I myself quit reading several minutes ago to watch ‘The Larry Sanders Show,’ pressing F9, the auto-pilot key that activates a macro – devised at M.I.T., no doubt – that captures the gist of where I was headed and then finishes the column for me), is that the Treasury is about to issue a whole slew of new TIPS, both 20-year and 5-year. Indeed, the prospect of that added supply may be one reason TIPS have fallen off yet a bit more (the 3.375%s of 2032 closed Friday at 116-and-change), and may have further to go.
But as I’ve said from the outset, I don’t see TIPS as a way to get rich, but rather as a way to sleep well. Twenty-eight years from now, when mine mature, I expect they’ll be worth about double what they are today – in real, 2004 dollars – which is to say 28 years of 2.5% growth (which is roughly a double) on top of inflation (which is what allows me to imagine all this in ‘today’s dollars’). Not a spectacular return, by any means. But as a core holding within a retirement account? Why not.
Tomorrow: Meet Mr. President
Quote of the Day
Between persons of equal income there is no social distinction except the distinction of merit. . . . That is why idiots are always in favour of inequality of income (their only chance of eminence), and the really great in favour of equality.~George Bernard Shaw (with whom I feel like an idiot disagreeing)
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