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Author: WendyBG Big gold star, 5000 posts Top Favorite Fools Feste Award Winner! Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 464985  
Subject: Re: Feds Weapons at Zero Interest Rates Date: 2/12/2006 11:52 AM
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<As a genuine hedge against deflation the long bond is a good choice.
I can envision a scenario where TIPs do nothing but return principle.
Certainly not much of a hedge against deflation, at leasst not anymore than cash.>

Mish, TIPS are guaranteed a small interest rate over inflation, a "real" interest rate (assuming the CPI-U is accurate, but that's a different question).

Ordinary (non-inflation-adjusted) bonds yield a nominal rate, which may or may not be higher than inflation. At this time, the real interest rate of the short-term bond is about average, while the interest rate of the long bond is lower than the historical average.

http://www.martincapital.com/chart-pgs/CH_mmnry.HTM

The problem with the long bond is its extreme price volatility. The price of a bond fluctuates with prevailing interest rates in proportion to its duration. That is, a 1-year bond will drop about 1% in valuation, for every percent rise in prevailing interest rates. A 30-year bond will drop about 30%, for every percent rise in prevailing interest rates. (The actual values are Net Present Values, which are exponential functions, so the drop is actually greater, the longer the duration of the bond.)
http://www.investopedia.com/university/advancedbond/advancedbond2.asp

If the owner of the bond has to sell the bond, the value of a long bond may be a pathetic fraction of its original value, if prevailing interest rates are higher than when the owner purchased it.

So, the purchaser should ask:
If deflation occurs, will it lead to lower interest rates (which will increase the value of the bond)? Or, will a deflationary recession lead to higher interest rates (stagflation, or perhaps, the avoidance of U.S. securities by foreign buyers)?

If deflation occurs, will it persist over the entire lifetime of the bond? If deflation occurs, the powers that be may respond by monetary and fiscal pumping, leading to subsequent inflation. Interest rates are likely to rise, if inflation rises.

Even if you predict a recession and deflation for the next 10 years (deflation persisting, despite all efforts to increase the money supply), are you so sure that it will persist for 30 years that you are willing to bet money on it?

I remember attending an investment seminar, in 1979 (a high inflation year). A woman said that she had some 8% bonds, but prevailing rates for that maturity had risen to about 14%. She asked, plaintively, what she could do, since the value of the bonds had dropped dramatically. The advisor shrugged, and said that she was stuck.

I never forgot it.

My first rule of investment is: Never lose money.

I am willing to accept a low return, if I think that the compensation for accepting risk is low...as it certainly is now, especially on the high-risk, long-duration end.

Personally, I am buying 6-month T-Bills, which yielded 4.669%, at Monday's auction. I am certainly not buying long bonds, which do not compensate me for the risk (price volatility) of holding them.

Wendy
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