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Author: globalist2013 Big red star, 1000 posts Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 35392  
Subject: The Impact of Inflation on Yield Date: 1/30/2013 2:40 PM
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Standard Disclaimers: The following post is not a recommendation to buy (or to avoid) the issuer mentioned. The post is merely a theoretical exercise that happens to use actual data.

Inflation is one of the many financial/economic buzz words that gets tossed around without most users ever defining what they really mean by the term. The current CPI index (and its variants) -- as they are produced by the Ministry of Economic Propaganda (aka, The Bureau of Labor Statistics)-- is just fluff and horse feathers. That wasn’t always the case. The pre-1980 series is a useful measure of YOY price changes as the average household might have experienced them. Since then --due to “revisions”-- the CPI has become a political tool, rather than a useful measure of things worth measuring. (The history of those revisions --especially the politics driving the revisions-- is a post for another time and, probably, another forum than this one.) So, let’s use a street-level definition and a street-level example.

If a first-class postage stamp cost you $0.40 cents last year and $0.42 cent this year, and the changes were one year apart, then you know you’ve suffered a 5% increase in your costs. If the price jumped to $0.44 from its previous $.40, then you can conclude that you suffered a 10% increases in your mailing costs. If you create a line-item, household budget yourself and track your expenses on a year-over-year basis, it is simplicity itself to determine what your actually experienced rate of inflation has been, and --possibly-- you can use those numbers to project what your future experienced rate of inflation might become. I happen to know that my experienced rate of inflation is 6%. Other households, because they are buying a different basket of goods and services, will report different rates of experienced inflation for themselves. But what all of those calculated rate will have in common is that they will be multiples of the “officially” reported rate. Even worse, their impact is real as you will find out when to go to the grocery store or gas pump. So the numbers aren’t the make-believe that characterizes most of what passes for “economics”. Inflation is a not-so-hidden tax on your future income and wealth.

If you buy a bond, any bond, you need to worry about the impact inflation will have on your yield. Even if you’re buying a 90-day CD, inflation will impact your yield. The principal returned to you will NOT buy as many goods and services as it did previously. Do the math. If your experienced rate of inflation is 6% per year, then your 90-day inflation rate is 1.5%. If you were dumb enough to buy a 90-day CD offering 1% (ann.), then you had to pay taxes on your gain of ¼% at ordinary-income rates. Let’s guess that your effective, Fed-state combo tax-rate on ord-inc was 25%. So, whatever three-quarters of one-quarter is what your after-tax yield was, from which you now have to subtract your experienced inflation-rate of 1.5%. Opps. You lost money, didn’t you? In other words, you made a very risky, very irresponsible bet, and --very predictably-- you lost that bet (unless, of course, your intention in buying the CD was to lose money, aka, your purchasing-power).

OK, enough of skirmishing. Let’s dig into some bonds. Below is the current prices and yield for JCP.

Cpn Due Price CY YTM
6.875 10/15/15 100.750 6.8% 6.6%
7.650 08/15/16 99.000 7.7% 8.0%
7.950 04/01/17 97.000 8.2% 8.8%
5.750 02/15/18 91.500 6.3% 7.8%
5.650 06/01/20 85.125 6.6% 8.4%
7.125 11/15/23 86.000 8.3% 9.2%
6.900 08/15/26 83.430 8.3% 9.0%
6.375 10/15/36 77.750 8.2% 8.6%
7.400 04/01/37 86.725 8.5% 8.7%
7.625 03/01/97 80.000 9.5% 9.5%

Look them over and tell me --if you can --which would be the best maturity to buy? If a high Current-Yield were important you to, you might choose the 7.625’s of ’97. If a low entry-price were important to you, you might choose the 6.375’s of ’36. If the highest YTM were important to you, you might choose the same 7.625’s of ’97 (as previously), or, possibly, the 7.125s of ’23, for offering only slight less of a YTM, but being a lot closer in maturity. But what if the most important thing to you were the actual, after-tax, after-inflation yield for each bond? Which bond might be the “best” one to choose?

If you want to know the CY for a bond, you can look it up or ask a bond calculator to produce the number for you. If you want to know the YTM for a bond, you can look it up, or you ask a bond calculator to produce the number for you. But if you want to know the tax-adjusted, inflation-adjusted yield for a bond, you’ve gotta build a spreadsheet. Depending --of course-- on how clearly you can frame the problem, and how fast you can write code, about ten minutes work is all it should take you to create a useable spreadsheet. So, creating the tool is no biggie. Let’s assume --Presto, Magico!-- that the task has been done and that our spreadsheet produces the following table (where our CG tax-rate is 15%, our ord-inc tax rate is 25%, our inflation rate is 5%, and prices are based on a purchase of one bond with a $10 commish.)

Cpn Due Price Adj_Cpn Adj_YTM
6.875 10/15/15 100.750 4.83% 0.0%
7.650 08/15/16 99.000 5.26% 1.1%
7.950 04/01/17 97.000 5.39% 1.8%
5.750 02/15/18 91.500 3.81% 1.1%
5.650 06/01/20 85.125 3.54% 1.6%
7.125 11/15/23 86.000 4.11% 2.0%
6.900 08/15/26 83.430 3.72% 1.9%
6.375 10/15/36 77.750 2.68% 1.2%
7.400 04/01/37 86.725 3.08% 1.2%
7.625 03/01/97 80.000 0.74% -0.5%

Again, let’s ask our same, basic question. Which might be the best bond to buy? Clearly, if a tax-adjusted, inflation-adjusted YTM were what is most important to you, then the 7.125’s of ’23 should be chosen. Nothing else offers a better return. However, now comes the realities of bond-investing. Is that bond, really, really, really the best one tactically to be buying? JCP is in a world of hurt. Its survival isn’t all that assured. A Chapter 11 filing isn’t unlikely (though the shape of the yield-curve predicts that traders aren’t yet pricing in a default). When you’re worried about an issuer failing, the last thing you want to be doing is to be buying their bonds a long way away from your likely workout-price. What’s the highest-priced bond in that list? The 6.875s of ’15, right? That’s just two years away. If a Ch 11 filing were immanent, the bond wouldn’t be priced as it is. So the higher probability bet is that bond will mature. But take a look at your effective-yield, which is zero. Do you really want to be putting money at risk in order to accomplish –-at best-- a scratch trade? That’s just stupidity. You might be able to get away with it this time. But sooner or later, such buying is going to cause you grief. You’re accepting risk, but without being offered commensurate reward.

And while we’re at it, look again at the 7.625’s of ’97. Yeah, in nominal terms, this maturity offers a fat, 9.5% Current-Yield. But look at how much of your principal will be returned to you, a mere $16.05 of your original $791.00 purchase price.(1) Ouch! That hurts. That's an “annuitization” you can choose to do. But I wouldn’t advise doing it with a Caa1-rated issuer. If you want to swap the return of your purchasing-power for a stream of current-income, then pick an issuer that’s likely to be still in business over the full course of your holding-period.

OK, look again at the table of adjusted-yields. If you assume a 5% inflation-rate, then the 7.125’s of ’23 edge out the 7.950s of ’17 by a little. Said another way, if you go with the earlier-dated issue, you capture 86.9% of what choosing the longer-date issue would offer in terms of adjusted YTM, plus you’d only sacrifice 0.1% of nominal current-yield, and you’d be getting out 6.6 years sooner. However the “cost” of making that choice would be a higher entry-price, which exacerbates your Ch 11 workout-risks. In short, there are never good choices. Everything is a compromise, and if there’s not enough things wrong with the situation --as Mary Whitman has said-- then the possible gains aren't worth pursuing. So, nearly always, you’re merely trying to choose the least worst of some really bad stuff, all the while trying to keep yourself out of more trouble that your account could manage.

As always, this post has gotten longer than I intended, and I haven’t even covered a tenth of the points that need to be made. But I’d suggest you do this. Build yourself a spreadsheet for calculating tax-and-inflation-adjusted YTMs. And build it with enough flexibility that all variables can be changed with a key stroke with all rows and columns auto-updating. That way you can process hundreds of bonds at a time, which is how you filter for the very few that might be worth digging into deeper. Also, which bond looks best out of a yield-curve under one inflation-rate isn’t necessarily the same as the best under another, due to the impact of the holding-period. I.e., the relative mappings seem to be invariant. But the absolute mappings aren’t, which means that your guess about inflation should be pretty close to a worst case scenario for yourself, so it can hold up over long time-frames. You do NOT want be be making money on paper from your investing, but find that you're short in the reality of the grocery store who is re-pricing faster and higher than you allowed for.

Charlie
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Postscript:

The purchase-price number and purchasing-power number in that referenced paragraph (1) come from my spreadsheet. Your SS should produce similar numbers. You've gotta know what you're spending to get what in return --and the likelihood of the latter event-- otherwise you're just 'gambling' in the worst sense that that term. Investing is just a betting game (aka, glorified 'social gambling'). But there's smart ways to be betting, and there's some really dumb ones. Building your own tools helps you put the odds on your side, so that you're taking more money --more genuine purchasing-power-- away from the game than you're bringing to it. The average investors fails to do that, as the Dalbar 20-year studies of investor results document in irrefutable detail. That's a problem that Wall Street, and the regulators, and the educators, and the Motley Fool have no intention of fixing. They like 'dumb money'. It makes for easy pickings and an eager audience for their products and "services". But with just ten minutes work, you could build a pretty decent spreadsheet and be on your way toward understanding what your bond yields really are. And if you don't build it yourself, you won't --and shouldn't-- trust its numbers. GIGO.
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