What’s the safest kind of Bond?

A bond is a promise to pay you a stream of future payments with your principle being returned at the end of the holding period.  We’ve been discussing asset management in a crazy economy.  In the last couple posts, we began looking at the devastating effects of inflation on a bond.  Today we’ll look at a type of bond which is created to protect against this risk.

Treasury Inflation-Protected Securities (TIPS)

TIPS are a type of bond meant to protect you the lender from inflation eroding away the value of your principle.  They work very similarly to other Treasury Bonds except that they pay a much lower interest rate.  However, when the principle is returned to you, the amount that you get is indexed to the Consumer Price Index (CPI) which the US government puts out as a measure of inflation.

So if you have invested $100,000 into a 10 year TIPS Bond and over the course of the 10 year period the CPI has gone up 100%, the Treasury will return to you $200,000 at maturity of your bond.  Thus you are sacrificing the amount of ongoing interest that you receive but receiving the CPI inflation protected amount that you had originally invested (which should be a much larger amount unless we experience serious prolonged deflation or the bond was not held very long.  You can read the Treasuries explanation at http://www.treasurydirect.gov/indiv/products/prod_tips_glance.htm.

However, let’s look at some potential dangers we see with this type of bond.

1)      The US Government determines the CPI index.  They change the components of it over time.  Their incentive is to have low inflation.  At the time of this writing in mid-2010, the cost of food has increased by 26% over the last year, yet this does not show up in CPI.  Shadowstats.com maintains the US Government’s official way of measuring inflation from 1980 which shows that inflation has been 9.5% over the last year.  But CPI shows a very negligible number for inflation.  So while you are receiving an amount indexed to a measure of inflation, this measurement might be substantially short of actual inflation.

2)      If we’re experiencing hyperinflation around the time that your TIPS bond comes due, the value of the Dollar could change substantially between the time the value is calculated and the time that you actually receive your principle and are able to get it reinvested elsewhere.  This doesn’t strike us as nearly as big a risk as the first point, but if this bad timing did happen, it could be important.

3)      What is the US Dollar ceases to exist?  This is hard for any of us to imagine right now, but there has never been a fiat currency to not go under because the government involved with each currency always ends up printing and borrowing it to oblivion.  We would have to completely ignore all of history to believe that it is not a possibility for this to happen to the US Dollar.  Now, will it happen in our lifetimes?  We have no idea.  But if it did happen while you owned TIPS bonds, what would happen to your money?  We have no idea.  But this seems like a risk to us in what is considered a very low risk investment.

With all that being said, TIPS are probably safer than any other US Bond (if you do believe inflation is coming) and so it should be considered for part of your portfolio.

After writing the above, the following quote came to us by way of David Galland at Casey’s Daily Dispatch on exactly this subject…

If the CPI doesn’t reflect what’s going on in reality, by happenstance or by manipulation, you could find the value of your inflation hedge rising much more slowly than the value of the dollar is falling. And there is plenty of reason to suspect that will be the case.

Much has been made of the CPI’s deficiencies. While the government has claimed a 3.3% inflation rate over the past decade, college tuition rose 8%, healthcare jumped nearly 10% annually, and even the cost of food jumped 7% per year from 2002 to 2009. The widely respected Shadow Government Statistics website has done extensive research on the subject and suggests that the real rate of inflation, which is reflected in your dollars’ declining purchasing power, has been vastly different than the CPI for most of the last 30 years:

If you have any thoughts or questions on this or other topics, please let us know.  Next, we’ll consider shorting Treasury Bonds.

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