April 25, 2015

The 30-Year Treasury Bond Yield Continues to Amaze Me

This afternoon, I purchased some additional shares of Berkshire Hathaway for the KRIP plan as I did general maintenance work on the portfolio holdings, examining dividend yields, look-through earnings, global distribution of assets, et cetera.  I noticed that the 30-year Treasury bond yield is now 2.8%.

This is beyond insane.  The Treasury bond yield was 2.99% last September when I mentioned that we should rename them, “Financial Suicide Bonds” for the sake of truth-in-advertising.  What rational person would buy a 30-year Treasury bond at these levels?

Imagine you wanted to lend the United States Government $100,000.  They promise to give you the entire $100,000 back on May 15th, 2042.  In the meantime, you will get checks amounting to roughly $2,800 direct deposited into your bank account each year.  That figure will never grow.  Plus, you have to pay taxes on the interest income you generate because interest income from Treasury bonds is exempt from state and local taxes only, not Federal.

Using a quick back-of-the-envelope analysis (ignoring things such as semi-annual nature of the coupon payments), what would the economic outcome be for an investor who bought a 30-Year Treasury bond today, was in the 25% income tax bracket, and held until maturity in 2042?  How much purchasing power should he or she receive in exchange for giving up three decades of enjoyment on the money that had been saved?

Analysis of 30 Year Treasury Bond Yields for Inflation

Analysis of 30 Year Treasury Bond Yields for Inflation

Over 30 years, the interest income would amount to $84,000.  You’d pay a total of $21,000 in income taxes if you were in the 25% tax bracket, leaving you with net interest income of $63,000.  Plus, you’d get your $100,000 back at maturity for a total of $163,000.

However, if inflation ran the same 4% that it has for the past century, the after-tax economic purchasing power equivalent of your interest income would be $36,313.  At the same time, when you got your $100,000 back at maturity, it would only have the purchasing power of $30,832 today.  Thus, for waiting 30 years, you were rewarded by watching your $100,000 in savings drop to $67,145 in purchasing power, for a real, net loss of $32,855.

Your paper profit would have shown $84,000 before taxes.  Yet, you really lost $32,855.  This is why you need to understand tax rules, inflation adjustments, and above all, purchasing power.  The results are even worse for those in higher tax brackets – this is just for the typical middle-of-the-road American!

If this were the only available investment opportunity present in the world, I wouldn’t even bother saving my money.  I’d spend every penny on diamond-tipped David Oscarson fountain pens, vacations to Bora Bora, a couple of Bentley’s in the driveway, and dinner out every night at $300+ steakhouses.  Presented with these terms, saving and investing money would be irrational.  Money is about utility.  Investing only makes sense if you are adequately compensated for delayed gratification and risk of loss with increased purchasing power on an after-tax, inflation-adjusted basis.

The only possible justification for long-duration Treasury bond ownership at these levels is if someone believes that we are going to enter a deflationary spiral on par with the Great Depression or the disaster that was the 1870’s.  I’m in the opposite boat, personally.  I think the central bank will monetize the debt and we’ll see signifiant inflation at some point in the future.

Tell you what.  To prove my point, any of you wanting to buy Treasury bonds, how about you call me, instead?  If you have at least few million dollars to make it worth the time, I’ll gladly bring in the lawyers to structure some sort of private deal.  Heck, I’ll even throw in an extra percentage point or two as long as I get to keep the 30-year maturity.  Anyone would be insane not to take those terms.  Economically speaking, it’s free money.

  • Matbu764

    I often wonder how much of the current low yields can be explained by certain entities being mandated to hold AAA rated assets.  A lot of formerly AAA rated assets got downgraded during the financial crisis, a lot of European sovereign debt was also downgraded recently.  If you run a pension fund,  insurance company or bank that must fulfil certain requirements on holdings of AAA rated assets you may be forced into the few large liquid markets of these that are left, U.S Treasuries, UK Gilts and German Bunds even though you know you’ll lose money, which I imagine might explain some of the reason they all have horrible yields  right now.

    You’re right of course, I would stay well away as an individual investor too, but the above might explain some of the apparent irrationality.

    • Joshua Kennon

      I think you hit the nail on the head.  It must be at least partially responsible.  Otherwise, people are dumber than I fear, which I am not ready to concede.  

  • http://AJCiti.com AJ

    I agree with everything you’ve said except the spending spree part. If you spent all the money now then you wouldn’t have anything in the future (even though the money would buy you less). Would that really be the wisest choice?

    • Joshua Kennon

      There are two ways to address this:

      1. If you lived in a society where all savings lost value each year and there was no alternative to keep up with inflation, saving money would be irrational. If, for example, we both were living in a situation like the Weimar Republic and the inflation they experienced there, the best thing to do would be to get whatever enjoyment you could out of your capital and / or (better yet) leave for greener pastures.

      2. You know how we talk about growing richer is a symptom of specific behavior, not a cause in and of itself? For me, that extends to my habits. So even if I were spending money, I’d find a way to do it intelligently. That means buying things that tend to appreciate over time and, often, getting them for the lowest price possible (there is an old retailers creed, “Well bought is well sold” that I follow). For example, several years ago, I was able to buy a Montblanc watch for $1,800 that now routinely goes for $4,400. I have no intention of selling it, but if I ever wanted to do so, I would certainly have earned a rate of return slightly higher than inflation. Likewise, I collect fountain pens. If you pay a low enough price for the genuine article, you could always feed your family if you have a David Oscarson pen lying around somewhere. No matter what happens to the currency, someone, somewhere, in some nation is going to want one and be willing to pay for it.

      To put it another way, if we were in a terrible mass-inflationary world, it may *look* like I was dropping $12,000 on a sterling silver flatware set, but the sterling silver flatware set has a liquidation value tied to silver that should have a very good chance of performing favorably relative to a quickly depreciating currency.

      In that sense, I it wouldn’t really be spending money, but rather allocating to things that both gave me a sense of enjoyment and utility (e.g., silverware) and could beat inflation so my purchasing power was protected. The trick there is knowing what has value and what doesn’t. I once read an article about an insurance company refusing to insure a collection of limited edition Precious Moments dolls that cost a lady more than $100,000 and she didn’t understand that they were essentially worthless; there was no secondary market and the material itself had no practical value. That is the art part of investing, just like spotting a good real estate deal. You have to know value when you see it. That is why you find people specialize, so often, in niches. I know nothing about 18th century Chinese silk screens but there are a handful of men and women on the planet that could make a fortune trading them.

      It really comes down to protecting your purchasing power. Long-term, the best option is almost always ownership of a great business. As the saying goes, even if American fell and we traded sea shells instead of dollars, whomever owns Coca-Cola is still going to be richer than everyone because most men and women will want a Coke or Diet Coke.

      It was more a theoretical observation that was meant to reinforce the idea that your job is to get the most purchasing power out of your investments. If things really were that bad, yes, I would try to “spend” all of the currency I had by doing something like buying a farm, buying commodity assets like oil wells, acquiring silver antiques, etc.

      But I wouldn’t be spending my wealth, I just wouldn’t want to hold any of it in the nominal currency of my home country.

      In other words, if your great grandparents left you all of their savings from the Weimar Republic, it would be worthless today. If, instead, they left you a silver antique mantel clock, a grand piano, a set of sterling silver flatware, and diamond cufflinks, they would still have value even though the currency has changed.

      I hope the distinction makes sense. I’m sorry I don’t have time to edit it and make it clearer, I just happened to see your comment when I got up to get something to drink.

      • http://AJCiti.com/ AJ

        Perfect explanation, I totally understand now. Thank you :)

  • rmc

    a decline in yield on the 30 yr bond from approx 4% in July 2010 to 3% in July 2012 would give you appreciation in the bond price of over 20% , not including the interest payments. In 2008 30 yr treasury Bond returned 42% (37.5% in appreciation and 5.5% in yield) while S & P 500 dropped 39%

    • Joshua Kennon

      This is a real question:

      How is any of this relevant to the discussion? We were looking at the mathematics of a new bond investor buying a 30-year bond in May of 2012 with the intention to hold it until maturity.

      You are saying that when bonds were cheaper, in 2008 and 2010, respectively, they had good subsequent performance to individuals who traded them. (The implication must be trading, not investing, because if held to maturity, the 37.5% appreciation gain you mentioned for 2008, for example, will eventually disappear as the yield-to-maturity regresses to the nominal yield closer and closer to maturity. The only way to lock that gain in is to sell the bond, otherwise it is a wasting asset that disappears when redeemed.)

      How does that change the projected after-inflation returns from holding bonds long-term issued in May of 2012? How is this in any way germane?

      I’m trying to figure out your point … maybe I’m just missing it?