Great Depression Online Archive Issue:

An Innocent Indiscretion

Great Depression Online
Long Beach, CA
August 12, 2008

Inside This Issue You Will Discover…

*** An Innocent Indiscretion
*** Price Fluctuations In A Nut Shell
*** When Is The Best Time To Buy Bonds?
*** And More

An Innocent Indiscretion

“Now is always the best time to buy bonds.”

This answer was delivered to us some years back with the conviction of a Baptist preacher.  We’d made the innocent indiscretion of asking a broker with Edward Jones ‘when is the best time to buy bonds?’

We were in our early 20’s and new to the world of investing…a world we quickly discovered was inhabited by a diverse myriad of charlatans, hucksters, and mountebanks galore.

Here was a man we’d mistaken for an expert.  And we’d erroneously assumed that he was in the business of helping people invest for retirement. 

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But with the slippery insincerity of his answer that pretense slid away like a slimy banana peel…and we saw him for what he was.  There, before our eyes, stood a seller of snake oil…a seller of hopes…of dreams…of intangibles…of ‘securities’.

For he knew what business he was really in…the business of separating fool’s from their money.  And he’d erroneously taken our youthful curiosity for foolishness.

After checking our pocket to make sure we still had hold of our wallet…we made a hasty exit out the side door. 

Price Fluctuations In A Nut Shell

To the novice investor, understanding the price fluctuations of bonds can seem a bit counterintuitive.  In particular, the relationship between price and yield…when price goes up yield goes down. 

That’s because the coupon payment on an outstanding bond is fixed, thus the price fluctuates to adjust the market yield to current interest rates.  

For example, if interest rates drop from 10 percent to 5 percent over time…the price of the bond with a 10 percent coupon would double to reduce the effective yield to 5 percent.  So, you can see, as interest rates fall bond prices rise.  In a nut shell, that’s how bond prices fluctuate.

Of course there are other considerations, and volumes have been written on risk pricing and the spreads between various grades of rated bonds.

But if we just consider U.S. Treasuries – which are considered riskless as long as the U.S. doesn’t default on its debt – ‘when is the best time to buy bonds?’

When Is The Best Time To Buy Bonds?

As we suspected years ago...now is not always the best time to buy bonds.  In fact, right now historically looks like a bad time to buy bonds.  Sure, there may be other opinions.  But we like to take the lazy man’s approach to this sort of thing.

Let us explain…

When buying bonds the lazy man’s way, you want guaranteed high yields.  In other words, you want to lock in your rate when they are at historic highs.  This has two advantages.  First you get the high rate of return each year.  Plus, as rates fall over time, the price of the bond goes up…and you can sell.

Of course this lazy man’s strategy takes some knowledge, patience, and deliberation.  First let’s look at inflation.

The current inflation rate as of June 2008, based on the Bureau of Labor Statistic’s Consumer Price Index, is at 5 percent.  Too, it seems that inflation is increasing…not decreasing.  The CPI for June 2007 was 2.7 percent.  And for June 2002 it was 1.1 percent.

Next, let’s look at interest rate cycles.

Interest rate cycles span long periods of time…often they last between 25 and 35 years.  

U.S. Treasury yields reached a peak in 1920 and then slowly slid until the mid 1940’s.  Then, they rose again – along with inflation – and Franz Pick famously declared that “Bonds are certificates of guaranteed confiscation”.

But then, in early 1982, yields again ventured over the mountain and slid down a soft slope to historic lows in 2003.  They have bounced around near the low margin since then.

Thirty year U.S. Treasury Bonds were yielding 4.54 percent last Friday.  At a 5 percent rate of inflation we consider a 30 year Treasury Bond yielding 4.54 percent to be a ‘certificate of guaranteed confiscation.’  Plus as inflation accelerates, while the 4.54 percent yield is fixed, the rate of confiscation accelerates too.  In this respect, we consider now to be a bad time to buy bonds.

As for the best time to buy bonds…that comes along only about once per each adult individuals lifetime. 

It happened in 1920 and then again in early 1982.  In fact, in January of 1982 the lazy man could have bought a 30 year U.S. Treasury Bond yielding 14.22 percent.

We anticipate the best time to buy bonds will again appear sometime around 2040 and yields could be close to 15 percent – or more.

Of course, this is all conjecture.

Sincerely,

M.N. Gordon
Great Depression Online

P.S.  U.S. Treasury Bonds yielding 4.54 percent may be a ‘certificate of guaranteed confiscation’, but heck, who cares when you’re making annual returns of +21.4%.  Learn more here: Half-Priced Stocks.

 

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