Friday, May 29, 2009

US Bonds: Not Worth The Risk

Despite the yield of the 10-year US Treasury bond rising to 3.76%, bonds are not worth the risk that the return will be canceled out by inflation. Martin Hutchinson argues that bonds are not a safe investment, and it's not because he thinks the US will default. To learn more see the following article from Money Morning.

With budget deficits on the rise and inflation almost certain to follow, it’s getting easier to see why British or U.S. government bonds are no longer a truly safe investment.

Standard and Poor’s Inc. (NYSE: MHP) last week put Britain’s credit rating under review for a possible downgrade, a precursor to a potential reduction in the country’s AAA credit rating. Since that indignity was avoided even in 1976, when Britain had to be bailed out by the International Monetary Fund (IMF), this raises questions about the safety of an investment in Britain’s government debt.

Needless to say, Britain and the United States have pursued similar policies in response to the ongoing global financial crisis, and are currently running similar budget deficits: Britain’s budget deficit this year will be 12.3% of gross domestic product (GDP), compared with 13.2% for the United States, according to The Economist.

Given those parallels, Britain’s credit review has to raise questions about whether a similar fate might await U.S. Treasuries. Indeed, the 10-year U.S. Treasury yield has already risen to 3.45% from its low of 2.07% in December, and it appears likely to rise even more.

That brings us back to my opening question: Should individual investors who are subject to inflation even consider U.S. Treasury bonds as a safe and secure investment?

Let me give you an extreme example - one that has jaundiced my entire view of government bonds since childhood. My Great Aunt Nan, a favorite relative in my childhood who had operated a small business, retired at 65 in 1947, having been born in 1882, one year too early for a self-employed person to qualify for a government pension in Britain. That was no problem, however - she had pretty substantial savings, which if invested prudently would give her enough income for a comfortable retirement. So she invested those savings prudently - and, indeed, patriotically - in a British government “War Loan” then yielding 2.5%, a “consol” paying income perpetually, with no maturity date. It gave her a retirement income of about 400 pounds a year, equivalent to about $30,000 today.

Actuarially, she was lucky - she lived in quite good physical and mental health to 91, which meant many happy visits to her during my childhood in the 1950s and 1960s.

Financially, she was rather less lucky, and suffered from an investment one-two punch:

  • First, the War Loan in 1973 - the year of her death - yielded 10.8%, so the nominal value of her savings had declined by 77% (since the market value of a bond moves opposite the direction of interest rates).
  • Second, consumer prices increased by 227% between 1947 and 1973, so the real value of her income had declined by 69%, and the real value of her savings had declined by 93%.

Government bonds - a safe investment. Yeah, right …

Obviously, there are examples that make the opposite case. For instance, if you had invested in long-term U.S. Treasuries in 1981, when they yielded around 15% (the U.S. prime rate actually reached 21.5% during that period), you would have done very well, indeed: The U.S. Federal Reserve, having finally vanquished inflation, embarked upon a rate-reduction campaign that brought American interest rates down at a steady rate for much of the rest of that decade.

But since governments control both monetary and fiscal policy - and since politicians are politicians - they combine to engineer things so that there are far more bad years than good years to be an investor in government bonds. Central banks and insurance companies buy government debt because they have to, but there’s no reason for you and I to get involved in these unattractive one-way bets. Even at 3.5%, 10-year U.S. Treasuries are a positively bad investment, since the U.S. budget deficit is so large that supply of them will never be limited, while inflation looks likely to reappear in force, draining the value of these bonds as inflation did to the savings of my great-aunt.

As daunting as all this all sounds, it’s not the worst that could happen: We still haven’t considered the possibility that the government could actually default on its debt.

Economists will tell you that governments can’t default on bonds in their own currency, because they can always print more money. In extreme cases, printing more money will lead to high inflation or even hyperinflation, leading to an effective repudiation like that perpetrated on my great aunt, or even like that carried out by the German Weimar Republic in 1923, when German prices were measured in the trillions of marks.

Economically, to avoid Weimar 1923, it would be better for a government to default outright, because at least non-government bonds and shares would still be worth something, and values would not be altogether destroyed.

After all, think about it - which would you expect to provide better investments: private companies, which create value, or the government, which merely spends money?

There are no sure things in life, but there are better investments and worse ones. Today, Brazilian government bonds, currently yielding 11.86% in Brazilian reals for an eight-year maturity, are a sounder investment than U.S. Treasuries; Brazilian inflation is expected to run 4.4% in 2009, so that’s a real yield of 7.46%, and the Brazilian budget deficit is only 2% of GDP.

Gold is always attractive while you think inflation is imminent - even at its current price, which is close to $1,000 an ounce. The gold market at $100 billion a year of production is far too small for the potential demand from central banks and speculators, so if inflation gets a real grip, the price of gold could easily go to $5,000.

Then there are stocks. Not cyclical stocks, which will suffer badly if the government finance chaos causes an even deeper recession than we already have. But shares in modestly leveraged companies producing low-priced consumer staples, which will continue to be purchased in even the deepest recession. In this area, think about such companies as The Procter & Gamble Co. (NYSE: PG), The Coca-Cola Co. (NYSE: KO), The Hershey Co. (NYSE: HSY) or, for lowish-priced entertainment, why not Nintendo Co. Ltd. (OTC ADR: NTDOY)?

In one way or another, Procter & Gamble, Coca-Cola, Hershey and Nintendo add value to our lives.

And to my way of thinking, that makes each of these a much better investment than a debt-ridden government. Don’t you agree?

This article has been reposted from Money Morning. You can view the article on Money Morning's investment news website here.

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