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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 Hold
Johnson & Johnson 4.950 05/15/33 113.228 4.03% 21.7
Xto Energy Inc 6.100 04/01/36 134.581 3.90% 24.6
Kreditanstalt Fur ufbau 0.000 06/29/37 37.505 3.83% 25.8
Xto Energy Inc 6.750 08/01/37 143.129 4.05% 25.9
Johnson & Johnson 5.950 08/15/37 125.196 4.32% 26.0
Xto Energy Inc 6.375 06/15/38 141.513 3.87% 26.8
Johnson & Johnson 5.850 07/15/38 123.671 4.35% 26.9
President&Fellow Coll 5.625 10/01/38 119.832 4.37% 27.1
Trustees Of Princetoniv 5.700 03/01/39 126.496 4.09% 27.5
Microsoft Corp 5.200 06/01/39 113.537 4.35% 27.7
Johnson & Johnson 4.500 09/01/40 105.064 4.20% 29.0
Microsoft Corp 4.500 10/01/40 103.246 4.30% 29.1
President&Fellow d Coll 4.875 10/15/40 113.849 4.06% 29.1
Microsoft Corp 5.300 02/08/41 116.597 4.30% 29.4
Johnson & Johnson 4.850 05/15/41 110.109 4.25% 29.7
Cooperatieve 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 YTM
Johnson & 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.

I have argued this point in this forum for nearly a decade" "Safe" isn't safe when ALL of one's risks are considered. To the extent that a bond-investor attempts to avoid default-risk is typically the extent to which he has to take on inflation-risk. To the extent that one attempts to mitigate inflation-risk is typically the extent to which investment-risk (of which credit-risk is merely one type) has to be accepted. In other words, the past decade has shown that the message of hope, security, and safety that Lokicious preached in this forum to risk-adverse investors was a falsehood that systematically destroyed their purchasing-power and ensured their old-age poverty. But don't my word for it (or his). Run your own numbers. Ask yourself what sort of returns you are really achieving once you pay taxes on your gains and subtract a realistic rate of inflation. To his credit, Loki did get one thing right. He used to insist, before he disappeared, that "One should never take on more risk than is necessary to achieve one's financial goals." I wholeheartedly agree. "Why go looking for trouble?" But if one needs income, and if one uses bonds to achieve that income, then one cannot price the future to perfection, as he used to. The high-rate, easy-money days of the early '80s, and even most of the '90s, are long gone, a brief, halcyon period that might never return in our lifetimes. The present, financial landscape is different, and it requires a different strategy in which credit-risk has to be accepted. Not gobs and gobs of it, but *enough* that inflation can be overcome unless, of course, one is so abundantly monied that one's assets can be spent down at a rate that matches inflation and without without the fear of ever depleting them. But with facts like one in seven Americans are now on food stamps, one in sixth elderly are below the poverty line, 36% of Americans are not contributing anything to retirement savings, and 64% of Americans say they would need to borrow money if they had an unexpected expense greater than $1,000, the necessary conclusion is that very few families in this country have have the sort of surplus money that Lokicious does. Thus, while his advice might be good advice for his own situation, it probably won't work well for anyone else, just as what I argue for probably won't fit anyone else's situation, either.

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

Charlie
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