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No. of Recommendations: 6
The BLS reported that:"The Consumer Price Index for All Urban Consumers (CPI-U) increased 0.5 percent in July on a seasonally adjusted basis … Over the last 12 months, the all-items index increased 3.6 percent before seasonal adjustment." [from their website]

As a first step, let’s check their math. The reported index value for July, 2001 was 225.922 and for July, 2010, 218.011. That works out to be 3.628716 by my calculator, or 3.63% and close enough to their figure. If 3.6% is used as a threshold in a bond-scan for triple-AAA’s, how far out on the yield-curve would a buyer have to go in order to achieve scratch return (before taxes, but after inflation)? Below is the 16, currently-offered triple-AAAs that meet that threshold, where “Price” reflects the commish on a ten-bond purchase; “Settlement” will be 09/02/11; and “YTM” is as E*Trade or Excel calculates it.
`Issue	                 Cpn 	Due 	        Price	YTM	HoldJohnson & Johnson	4.950	05/15/33	113.228	4.03%	21.7Xto Energy Inc	        6.100	04/01/36	134.581	3.90%	24.6Kreditanstalt Fur ufbau	0.000	06/29/37	37.505	3.83%	25.8Xto Energy Inc	        6.750	08/01/37	143.129	4.05%	25.9Johnson & Johnson	5.950	08/15/37	125.196	4.32%	26.0Xto Energy Inc	        6.375	06/15/38	141.513	3.87%	26.8Johnson & Johnson	5.850	07/15/38	123.671	4.35%	26.9President&Fellow  Coll	5.625	10/01/38	119.832	4.37%	27.1Trustees Of Princetoniv	5.700	03/01/39	126.496	4.09%	27.5Microsoft Corp	        5.200	06/01/39	113.537	4.35%	27.7Johnson & Johnson	4.500	09/01/40	105.064	4.20%	29.0Microsoft Corp	        4.500	10/01/40	103.246	4.30%	29.1President&Fellow d Coll	4.875	10/15/40	113.849	4.06%	29.1Microsoft Corp 	        5.300	02/08/41	116.597	4.30%	29.4Johnson & Johnson	4.850	05/15/41	110.109	4.25%	29.7Cooperatieve Centrale	5.250	05/24/41	105.353	4.91%	29.7`

Pretty sucky, right? Would-be buyers are facing a very flat YC, and they have to go very far out to do much better than nominal inflation. By way of seeing just how bad things are, let’s run the numbers for a couple of bonds. If a buyer selects Kreditanstalts’ 0’s of ‘237, he is betting that when his principal is returned to him, he will have achieved a positive return. That can be verified by discounting. In 2011, he invests \$375.05 of present-day purchasing-power per bond, and in 2037 he will receive \$398.22 of present-day purchasing power, for an implied, internal rate of return of 0.23%. Meanwhile, taxes will have to be paid each year on the implied interest received (unless the bond is held in a tax-sheltered account, in which case, taxes become due upon withdrawal.) But as long as inflation doesn’t average greater than 3.63% over his holding period, and as long as he will always be forgiven the taxes due on his gains, he will receive a positive return. Likewise, if a buyer selects Cooperatieve’s 5.25’s of ’41, then, though both principal and the coupon need to be discounted, the result will be an inflation-adjusted return of 0.98%.

Now run this exercise. Assume that one’s tax-rate on ordinary income will be 25%. (Equivalently, that the inflation-rate will be 4.84%.) What sort of returns are now achieved? If you’ve set your spreadsheet up so that the inflation-rate is an absolute cell reference, then the calculations are easy, and every bond in the list will lose you money. Now make this adjustment. Begin with a realistic rate of inflation, say 5%, but cut yourself some slack and keep the same tax-rate as before of 25%. Now, what is the damage to your purchasing-power?
`Issue	                Cpn 	Due 	        Price	   Inflation-Adjusted YTMJohnson & Johnson	4.950	05/15/33	113.228	     -2.46%Xto Energy Inc	        6.100	04/01/36	134.581	     -2.59%Kreditanstalt Furu	0.000	06/29/37	37.505	     -2.64%Xto Energy Inc	        6.750	08/01/37	143.129	     -2.48%Johnson & Johnson	5.950	08/15/37	125.196	     -2.25%Xto Energy Inc	        6.375	06/15/38	141.513	     -2.63%Johnson & Johnson	5.850	07/15/38	123.671	     -2.24%President&Fellow Harvar	5.625	10/01/38	119.832	     -2.23%Trustees Of Princeton 	5.700	03/01/39	126.496	     -2.46%Microsoft Corp	        5.200	06/01/39	113.537	     -2.24%Johnson & Johnson	4.500	09/01/40	105.064	     -2.38%Microsoft Corp	        4.500	10/01/40	103.246	     -2.29%President&Fellow Harva	4.875	10/15/40	113.849	     -2.49%Microsoft Corp 	        5.300	02/08/41	116.597	     -2.30%Johnson & Johnson	4.850	05/15/41	110.109	     -2.34%Cooperatieve Centrale 	5.250	05/24/41	105.353	     -1.83%`

Opps. Now, you’re no longer able to preserve capital, no matter how far out on the yield-curve you go. Now, in order to preserve capital, much less appreciate it, you have to take on credit-risk, which is exactly what Bill Gross has been arguing that FI investors need to do and exactly what they are reluctant to do, as they should be, because that’s a crazy thing to have to do, exactly on the lines of “We had to destroy the village in order to save it.” But that’s exactly game the Fed is now forcing fixed-income investors to play. By keeping interest-rates near zero and by flooding the market with liquidity, the Fed has disincentivize saving. With the market awash in cash, no one needs to bid for it. Therefore, they aren’t, and bonds that are relatively free of credit-risk aren’t offering a real-rate of return, just as they almost never do.

Run your own numbers, people. Those are the only ones you can trust.

Charlie
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