Investing Strategies / Risk

As discussed earlier, real and ultimate bond returns are highly 
dependent on duration/yield, inflation, and taxes on dividends rec'd.

Siegel's data on bonds, in the aggregate, clearly shows that the period 
from 1940-1980 was one long downhill slide in real and ultimate terms. 
sure there were several 6-12 month periods where bonds provided a good 
return, but over the long term bonds lost capital value for four 
decades. in real terms, no taxes or fees, he shows that bonds returned 
-62% in real terms from the top in 1940 to the bottom in 1980. in 
ultimate terms, with taxes, well- its pretty ugly. with taxes, bond 
holders still are not anywhere close to being "even" with 1940.

but that's the past, and tomorrow is the future and a lot of people are 
worried about valuation risks with equities.  so it's probably a 
worthwhile exercize to examine potential bond returns for the future. as 
the data clearly shows, bonds are highly susceptible to inflation risk, 
and to government tax policy. however, in the US we now have a inflation 
adjusted treasury bond - TIPS for short.  i believe that these bonds are 
a good deal overall for long term investors and i have discussed them 
before. but although they are designed to provide a positive real 
return, they are not risk free in the ultimate return sense, because of 
tax policy.  with a TIPS, you get a regular coupon payment twice per 
year, and once per year you get an adjustment for inflation based on the 
CPI-u.  however, the inflation adjustment is an adjustment to principal, 
not a cash payment, and worse yet, you have to pay tax on both the 
inflation adjustment and the coupon payment (hey - like ben franklin 
said - death and taxes). so, like a zero coupon bond, you have an annual 
tax liability without the actual cash flow. because the inflation 
adjustment is taxable, there is still inflation risk to TIPS.

TIPS yield 3.2% today. You have to plug in your own tax rate, for us 
it's 40%.

TIPS yield  Inflation  Total Yield  Yield after tax(@40%) Ult. Return
3.2            1          4.2            2.5                 1.5
3.2            2          5.2            3.1                 1.1
3.2            3          6.2            3.7                 0.7
3.2            4          7.2            4.3                 0.3
3.2            5          8.2            4.9                (0.1)


so, for an inflation rate of 5%, your ultimate return goes to less than zero.

compare to the muni bond alternative - i'll use Vanguard Intermediate 
term, with a current duration of 5 years and a current yield of 4.86%. 
with muni bonds you save the federal tax but still have to pay state and 
local income tax. i'll use 5% which is our Arizona level. 

Muni yield  Inflation  Total Yield  Yield after tax(@5%) Ult. Return 
4.9            1          4.9            4.6                 3.6
4.9            2          4.9            4.6                 2.6
4.9            3          4.9            4.6                 1.6
4.9            4          4.9            4.6                 0.6
4.9            5          4.9            4.6                (0.4)

clearly, at today's prices, if inflation stays under 4, 4.5%, tax exempt 
muni bonds may provide significantly more ultimate return, i say "may" 
because i am not addressing credit quality concerns between federal debt 
and muni debt.

what about the straight 10 year treasury. let's look at that. today it's 
quoted yield in the WSJ is 5.50%. i'll be generous and ignore bid/ask 
spreads and commission and just use that number. again, you have to make 
an assumption on taxes.

Tbond yield  Inflation  Total Yield  Yield after tax(@40%) Ult. Return 
5.5            1          5.5            3.3                 2.3
5.5            2          5.5            3.3                 1.3
5.5            3          5.5            3.3                 0.3
5.5            4          5.5            3.3                (0.7)
5.5            5          5.5            3.3                (1.7)

comparing the TIPS to the 10 year bond for an IRA (or other tax 
sheltered account)

Inflation   Ultimate Return TIPS    Ultimate Return Tbond
  1              3.2                       4.5
  2              3.2                       3.5
  3              3.2                       2.5
  4              3.2                       1.5
  5              3.2                       0.5

clearly, ignoring taxes, and ignoring reinvestment fees, the market is 
"pricing in" an inflation rate of 2.3%. if inflation is lower than that 
the regular tbond is a better deal in a tax sheltered account, if it is 
more, than the TIPS are a better deal.

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