Bonds vs. Inflation

[MichaelB]

I wouldn't take out those long term bonds. The bond latter I mean

Fixed income is absolutely necessary to diversify a portfolio, especially when in the withdrawal phase. When the portfolio is taxable, this becomes harder to achieve. In a rising rates environment, harder still. Short term tax exempt funds risk losing to inflation, longer term risk losing NAV to higher yield. TIPs are definitely not tax-efficient.

Building a bond ladder is a reasonable way to hold longer term bonds in a rising rates environment - vs a bond fund. By holding bonds to maturity you don't realize any loss in price, and each new year you capture a higher rate. This is a particularly opportune moment, as investment grade yields have been at uncharacteristically high premiums.

How else do you suggest holding fixed income in a taxable portfolio?

 

[dshibb]

"Fixed income is absolutely necessary to diversify a portfolio"
That is your problem right there. You are holding a principal taught under "normal circumstances" above the reality on the ground.

"TIPs are definitely not tax-efficient."
Don't care even if you don't purchase them in a tax sheltered vehicle. The inflation tax is worse that the income tax on TIPS especially when you sell them in rising rate environment and take more than half of you money in capital gains.

"Building a bond ladder is a reasonable way to hold longer term bonds in a rising rates environment"
No it isn't.

"By holding bonds to maturity you don't realize any loss in price"
Yes you can, you can lose in terms of real dollars.

"This is a particularly opportune moment, as investment grade yields have been at uncharacteristically high premiums."
There is no question that default risk is overpriced, but inflation risk is way more underpriced. Fixed income is getting hit twice in a row. The best time to buy fixed income is when Fed raises rates enough to try to shut down inflation. Example: Steve Wozniak sold out of Apple in the early 80s and purchased 30 year munis at 17%.

"How else do you suggest holding fixed income in a taxable portfolio?"
I can think of a few. Rate chasing in high yield savings/reward checking. In an increasing rate environment you get spot interest rate not one locked in. The only way that bonds would be comparable is if you really shortened up your latter like 3-6 months bonds.

And oil drilling programs. A nice conservative one will return 6-8% a year(paid monthly) at current oil price, since oil rises during inflation you're returns will rise with inflation. And oil would have to drop below $30 for the return to drop below 3%. Oh and did I mention that they are almost fully tax deductible.

 

[haha]

Many of us would benefit from a bit more doubt. The book, "On Being Certain", points out that the sensation of certainly is just a sensation, which often has little to do with rational thought or the actual probabilities involved in whatever one feels certain about.

It has quite a bit in common with the aura felt before an epileptic seizure, and shows similar brain activity.

Ha

 

[dshibb]

Ha I'm certain about the fact there will be at least a decent amount of inflation. It is my opinion that the vast majority of investors are going to way underestimate how much there will be. I am capable of drawing the distinction.

 

[FIREd]

There are so many risks out there that could impact my portfolio (market risk, interest risk, credit risk, inflation risk and political risk among many others) and I just don't know which one is going to put the next dent in my nest egg. I don't expect my investment plan to be perfect 100% of the times. I want my plan to be just good enough to allow me to retire.

When reading this forum and other financial media sources, it makes my head spins sometimes. People passionately make and defend their own prediction as if it was the only possible answer to an impossibly complex riddle: Inflation is coming, no deflation, the USD will crash, no it will rally, the recession is over, no it's just getting underway, this is a new bull market, no it's just a bear market rally... Clearly everyone is looking at the same dataset and yet there is no clear consensus. We might as well say "I don't know".

I have come to the realization that I have to tune out the noise and rely only on myself to make decisions concerning my portfolio. Yes I am worried about inflation, but I am not willing to bet the house on it either. Short term bonds seem to fit the bill for me right now. They may not be perfect but they help protect against inflation and against deflation. I-bonds do the same. I like that. It may not be glamorous, it may not be ballsy, and I sure won't hit a home run with them, but it's good enough. For me.

 

[MichaelB]

There are so many risks out there that could impact my portfolio (market risk, interest risk, credit risk, inflation risk and political risk among many others) and I just don't know which one is going to put the next dent in my nest egg. I don't expect my investment plan to be perfect 100% of the times. I want my plan to be just good enough to allow me to retire.

When reading this forum and other financial media sources, it makes my head spins sometimes. People passionately make and defend their own prediction as if it was the only possible answer to an impossibly complex riddle: Inflation is coming, no deflation, the USD will crash, no it will rally, the recession is over, no it's just getting underway, this is a new bull market, no it's just a bear market rally... Clearly everyone is looking at the same dataset and yet there is no clear consensus. We might as well say "I don't know".

I have come to the realization that I have to tune out the noise and rely only on myself to make decisions concerning my portfolio. Yes I am worried about inflation, but I am not willing to bet the house on it either. Short term bonds seem to fit the bill for me right now. They may not be perfect but they help protect against inflation and against deflation. I-bonds do the same. I like that. It may not be glamorous, it may not be ballsy, and I sure won't hit a home run with them, but it's good enough. For me.

Some good points here. There are many risks to deal with, including both inflation and deflation, and some very smart people are arguing opposite scenarios. None will stop by the house to bail me out if I follow their advice and it doesn't pan out, though.

The total portfolio return is what matters. I have used short term tax exempt bond funds for a number of years and am satisfied with the results. The sudden decline in bond prices created an opportunity to build a ladder, almost evenly split between tax free and taxable, with a yield far above what I was/am getting, so I jumped at the opportunity. Doing so eliminated some risk but created other risk. Was this the "right" thing to do? It fits my portfolio, and that's what counts.

In an environment like this fixed income is a risk. No fixed income is also a risk. The option I choose lets me sleep better at night and I still have options if it doesn't work as expected.

 

[haha]

I have pretty much stayed very short and very high quality, except the infamous ISM/OSM. And some TIPS and I -bonds, all bought at better coupons than are available today.,

Even if I had a high opinion of my credit analysis skill, which I do not, I think the legal ground is shifting under our feet and I would not have any confidence in my assumptions.

Over the past 24 months or so I have seen too many high probability scenarios get blasted out of the water by supposedly low probability scenarios.

An interesting sideshow is the good rally in Ford debt since GM and Chrysler bondholders have been roughed up by a stronger party. The market seems to interpret this as "Oh great, now Ford will be last man standing and should sell a lot of cars." But another way to see it is that if the recession drags on and Ford itself experiences credit stress (not a long shot in my view!) Ford bondholders are very likely to get the same rough treatment that has been dished to GM and Chrysler creditors.

More than fixed income securities what we need as retirees is durable cash flows. Over the past months some equities with very stable businesses have sold at what seem likely to provide excellent income and total return going forward. I feel a lot better about this kind of thing than I would about 10 year treasuries for example, or Ford debt. In stressful times the very best capital structure is all equity in a stable business.

Ha

 

[MichaelB]

I have pretty much stayed very short and very high quality, except the infamous ISM/OSM. And some TIPS and I -bonds, all bought at better coupons than are available today.,

Even if I had a high opinion of my credit analysis skill, which I do not, I think the legal ground is shifting under our feet and I would not have any confidence in my assumptions.

Over the past 24 months or so I have seen too many high probability scenarios get blasted out of the water by supposedly low probability scenarios.

An interesting sideshow is the good rally in Ford debt since GM and Chrysler bondholders have been roughed up by a stronger party. The market seems to interpret this as "Oh great, now Ford will be last man standing and should sell a lot of cars." But another way to see it is that if the recession drags on and Ford itself experiences credit stress (not a long shot in my view!) Ford bondholders are very likely to get the same rough treatment that has been dished to GM and Chrysler creditors.

More than fixed income securities what we need as retirees is durable cash flows. Over the past months some equities with very stable businesses have sold at what seem likely to provide excellent income and total return going forward. I feel a lot better about this kind of thing than I would about 10 year treasuries for example, or Ford debt. In stressful times the very best capital structure is all equity in a stable business.

Ha

Right. Your RIP thread highlights how things can change - even the seniority of one's claim. Along a similar line, all the credit default swaps out there completely change the risk profile for individual bond investors.

More than any time in history, mankind faces a crossroads. One path leads to total despair and utter hopelessness. The other, to total extinction. Let us pray we have the wisdom to choose correctly

 

[brewer12345]

While I recognize that the money supply expansion and various liquidity efforts of the gummint are potentially inflationary, it seems to me that all of this is merely a modest counteraction of the huge delevring going on in the private sector. In effect, some of the leverage coming out of the private sector is going into the public sector. Since this isn't spending (mostly), curtailing the liquidity expansion should be a lot easier to effect when it becomes necessary.

I AM leery of inflation long term, but for a different reason. For the past year or so and likely for the next year or three, nobody in their right mind is investing in productive capacity. When the recession ends and China & India resume their urbanization and development, we will be behind the curve in terms of the ability to make enough "stuff." Until the ramp up of capacity catches up with demand, we will probably see some pretty nasty inflation.

 

[dshibb]

If deleveraging was still an issue than markets will still be taking huge hits. Most of the hurt from that is behind us. On top of that most of the leverage is correlated with the real estate market, and those prices are starting to level off, and in many areas around the country the median price has actually rose slightly in the last few weeks. It was clear that the effect of deleveraging was going to happen more up front and the effect of soft money was going to have a later effect. The fact that deleveraging is halting its damage, and it has barely moved the base money supply of the united states off its extreme highs means that it just can't be as huge of factor moving forward.

 

[brewer12345]

If deleveraging was still an issue than markets will still be taking huge hits. Most of the hurt from that is behind us. On top of that most of the leverage is correlated with the real estate market, and those prices are starting to level off, and in many areas around the country the median price has actually rose slightly in the last few weeks. It was clear that the effect of deleveraging was going to happen more up front and the effect of soft money was going to have a later effect. The fact that deleveraging is halting its damage, and it has barely moved the base money supply of the united states off its extreme highs means that it just can't be as huge of factor moving forward.

I would dispute the notion that the leverage excesses were only related to real estate. There was quite a bit of excess leverage in many sectors of the "real economy" as well as in many corporate balance sheets. The high yield market and (especially) the leveraged bank loan markets went way, way, way overboard (think of all the stupidly overpriced LBO deals with little or no equity in them). There were also a lot of leveraged investment vehicles (hedge funds, SIVs, etc.) investing in just about everything (not just mortgage paper). So there was leverage all over the place.

The squeeze is starting to ease, but its only really just begun. The TED spread is under 100BP for real now, but its only just happened in the last two weeks and I think you will see the powers that be wait a little while before starting to back off the liquidity efforts to make sure this isn't a blip. Will they back off in time? We have no way of knowing for a while (years). Certainly inflation will be higher than it is right now (since it is close to zero at the moment), but whether it goes to harmful levels we will all find out within the next 5 or 10 years.

I'm happy to buy bonds with 10+% YTM if I think they are money good, but I am also keeping my maturities inside 10 years and mostly buying ~5 year paper. The likelihood that inflation gets to deleterious levels inside 5 years is pretty remote, IMO. After that, who knows?

 

[MichaelB]

While I recognize that the money supply expansion and various liquidity efforts of the gummint are potentially inflationary, it seems to me that all of this is merely a modest counteraction of the huge delevring going on in the private sector. In effect, some of the leverage coming out of the private sector is going into the public sector. Since this isn't spending (mostly), curtailing the liquidity expansion should be a lot easier to effect when it becomes necessary.

I AM leery of inflation long term, but for a different reason. For the past year or so and likely for the next year or three, nobody in their right mind is investing in productive capacity. When the recession ends and China & India resume their urbanization and development, we will be behind the curve in terms of the ability to make enough "stuff." Until the ramp up of capacity catches up with demand, we will probably see some pretty nasty inflation.

I agree and would add that avoiding inflation down the road requires the Fed to implement the appropriate policies at the right moment, something the incumbent leadership has not shown any particular talent for so far.

 

[dshibb]

"I would dispute the notion that the leverage excesses were only related to real estate."
Did I say only, no I said most.

I believe the time to have backed off to avoid excessive inflation has already come and passed. Now when the fed starts to act will determine the severity.

"The likelihood that inflation gets to deleterious levels inside 5 years is pretty remote, IMO."
I couldn't disagree more, I personally believe that inflation not being a factor until after 5 years is pretty remote. I'm just waiting for the velocity of money to pick up and bam it will show up quick.

"I agree and would add that avoiding inflation down the road requires the Fed to implement the appropriate policies at the right moment."
I have been a huge fan of Anna Schwartz for quite a while. I was so pleased that someone posted her most recent interview on here. Have you had a chance to listen to it? In that interview, Anna talks about the fed completely throwing its Open market activities to the way side in its response to crisis. They have thrown away almost all their treasuries and now have to much "toxic assets". Normally they could sell the treasuries on the open market and use that to help contract the money supply. How much are they going to be able to contract the money supply by selling "toxic assets"? The only thing that they will have to do is increase the fed rate, and that will lead to higher rates and another shutdown of credit.

 

[dshibb]

Take a look at the graphs I posted on page one. Now tell me since most of the deflation effects of deleveraging have already occured and you can see a minor blip on the money supply corresponding to that, what do you think will happen with all that excess money? Do you honestly think that if all the problems around Sept - Oct only caused a minor blip on that graph that deleveraging will bring that all back down to normal? I just can't understand how anyone can look at those charts and not think inflation is a) coming soon and b) that it will be pretty significant.

 

[brewer12345]

The only thing that they will have to do is increase the fed rate, and that will lead to higher rates and another shutdown of credit.

First, I am not sure that is correct. Second, raising rates after credit spreads have normalized shouldn't have that big an effect. What borrowers care about is their all-in rate. Right now, issuers are paying up on an all-in basis because spreads are so high. If spreads continue to drift down (and there is a lot of room for that to happen considering I have been buying 5 year BBBs at 600 to 800+BP spreads), there will be lots of room to raise the base rates.

 

[dshibb]

We're not taking about raising base rates a couple hundred BPs here, they are going to have to go well above 4% relatively quick when the velocity of money picks up. The recovery is still going to be relatively fragile at that point, do you think the economy is going to hold up with that?
You didn't answer my other parts of my last post.

 

[brewer12345]

We're not taking about raising base rates a couple hundred BPs here, they are going to have to go well above 4% relatively quick when the velocity of money picks up. The recovery is still going to be relatively fragile at that point, do you think the economy is going to hold up with that?

Sounds like 1993-4, when the fed funds rate was raised pretty far, pretty fast. Didn't seem to hurt the late 90s boom.

 

[dshibb]

Its not even in the same realm. First of all moving the base rate from 3 to 6 in one year is way different that moving the base rate from 0 to 4+ in half that amount of time. Also, the annual change in the money supply went from 4% to 11% over the course of several years, and then the fed did a 300 basis point increase over the course of 1 year. The fed just increased base by more than 100% in less than a year. Do you realize to what extent that the fed will have to raise base rates to counteract that? It will have to be at least 4% very quickly(much more quickly than 93-94) to even hold off the tide, and I'm not ruling out in excess of 15% to truly get under control.

The fact is that the monetary data that has come out of this current situation, is completely different than anything we have experienced in American history. You can't try to fit it in a box of historical norms because the data is so extremely far from historical norms. All you can really try to do is develop a general principal based on previous historical extremes and attempt to fit it in a wide scale based on current data. Then price the risk/return of that range. When you look at risk vs. return your plan just doesn't fit.

Lets take a look at bonds vs. TIPS in that context. If I'm wrong and deflation continues, gets worse, or inflation doesn't really occur. My range is as follows Bad deflation: holding the TIPS until maturity and getting my principal back upon maturity, Moderate to no deflation: selling off at a minor loss because I would rather put my capital to more productive use, or underperforming for example your bonds by lets say 8-10%. In each case I'm okay with that. Now lets take a look at the range if inflation does become an issue. The complete lack of historical reference on something like this has to cast a huge range. Nobody can legitimately say that 40% interest rates for example is physically impossible because the can't find any historical reference of increasing the money supply like the Fed has. So lets put a range of 5 - 40% on there. In the case of 5% I do pretty close in TIPS to what you are earning on quality corporate bonds. Now, care to take a guess how much of a beating you take if 40% interest rates get realized? You can't tell me its not possible. Who is taking more risk? Realistically how much return do I forgo if I'm wrong?

 

[MichaelB]

Lets take a look at bonds vs. TIPS in that context. If I'm wrong and deflation continues, gets worse, or inflation doesn't really occur. My range is as follows Bad deflation: holding the TIPS until maturity and getting my principal back upon maturity, Moderate to no deflation: selling off at a minor loss because I would rather put my capital to more productive use, or underperforming for example your bonds by lets say 8-10%.

That’s 8-10% per year. That’s a lot of money.

Nobody can legitimately say that 40% interest rates for example is physically impossible because the can't find any historical reference of increasing the money supply like the Fed has.

. Not impossible, but very unlikely.

So lets put a range of 5 - 40% on there.

No. 40% is neither reasonable nor likely.

In the case of 5% I do pretty close in TIPS to what you are earning on quality corporate bonds.

If real return is 1.5%, with 5% inflation you get 6.5% total return, vs greater than 10 – 12% from the BBB. Still a pretty big annual difference.

Now, care to take a guess how much of a beating you take if 40% interest rates get realized? You can't tell me its not possible. Who is taking more risk? Realistically how much return do I forgo if I'm wrong?

Actually, you are taking more risk by betting on the less likely scenario.

 

[dshibb]

I'm not betting on a less likely scenario. I'm covering my a$$ against a decent possibility. You aren't covering your a$$ against anything. My closer expectation ranges from 7% to 17% inflation. I mean do you realize that it is just as likely for you to be negative 10% in real dollars as it is for me to be underperforming your bonds by 5%(in this case I'm assuming 3% inflation). There is absolutely no validity to the notion that you're taking less risk with your corporate bonds. And reasonable assumptions put us about even or in my favor in the future. And by the way 40% inflation to you right now is about as likely as a 50% crash in the market was to someone 2.5 years ago. If there is a reason to believe they are possible, you at least need to acknowledge them.

But I'm starting to get bored of this. I'm just going to end up looking forward to the bragging rights in the future when inflation is in the double digits.

 

[dshibb]

By the way don't forget to discount your default risk.

 

[haha]

In investing it is often the "expectation", not the frequency, that dominates returns.

Ha

 

[MichaelB]

I'm not betting on a less likely scenario. I'm covering my a$$ against a decent possibility. You aren't covering your a$$ against anything. My closer expectation ranges from 7% to 17% inflation. I mean do you realize that it is just as likely for you to be negative 10% in real dollars as it is for me to be underperforming your bonds by 5%(in this case I'm assuming 3% inflation). There is absolutely no validity to the notion that you're taking less risk with your corporate bonds. And reasonable assumptions put us about even or in my favor in the future. And by the way 40% inflation to you right now is about as likely as a 50% crash in the market was to someone 2.5 years ago. If there is a reason to believe they are possible, you at least need to acknowledge them.

But I'm starting to get bored of this. I'm just going to end up looking forward to the bragging rights in the future when inflation is in the double digits.

Well, you seem sure of yourself and quite confident that you see something the rest of us don’t and know exactly how to take maximum advantage. You may be right. Good luck. And don’t forget to stop by regardless of the outcome. If things don’t turn out as you expect, I’ll buy you a cup of coffee.

 

[dshibb]

"Well, you seem sure of yourself and quite confident that you see something the rest of us don’t and know exactly how to take maximum advantage."
You are clearly in the minority, if you are expecting no/negligible inflation in the future.

 

[MichaelB]

"Well, you seem sure of yourself and quite confident that you see something the rest of us don’t and know exactly how to take maximum advantage."
You are clearly in the minority, if you are expecting no/negligible inflation in the future.

??

I’ve made it pretty clear I see the possibility of higher inflation. Where we disagree: I don’t believe it is a certainty, nor is it likely to reach double digits, and chronic deflation is still a possibility. The only certainty I have is that I don’t know what will happen, am trying to keep my options open, allow for either of these or something else (like stagflation) and take advantage of opportunities when they arise.

Fair enough?