Bondholders Beware


 

We spend a lot of time as investors trying to understand and mitigate risk.  Sometimes this can seem difficult as prices can move up and down drastically for seemingly no reason.  However, in studying the history of the stock market, we take for granted a lot of the risk that we no longer have to bear.  Prior to regulation that stemmed from the great depression, one of the biggest risks investors had to face were scams in which big companies or big investors changed the rules of the game to take advantage of the Main Street investor.  One of the simplest and most destructive scams was when companies (or counterfeiters) produced additional shares of stock, after selling an initial distribution to investors.  Back in the day, companies would literally print a certain amount of certificates, and sell them to the public, who would know what percentage of the company that stock certificate represented.  The idea for the stockholder was to share in that profits of the company and receive regular dividends as compensation for their investment. The scam is obvious. If 100 stock certificates were printed, each representing 1% ownership, and then 1000 new shares were printed, those original holders’ ownership was massively diluted, and the value of their certificates plummeted.  Fortunately, through regulated exchanges and better systems and technologies, this is no longer a risk stock holders bear.

So why do I tell this story?  Although there are no companies or criminal enterprises powerful enough to pull off this scam any longer, there is an entity that can change the rules mid-game so that it falls in their favor: The US Government.  This may seem like a stretch, but think about the arrangement the government has with its debt holders compared to a company issuing stock.

Both need to raise money to fund operations.  A company sells stock and promises to pay the purchaser a certain percentage of future profits.  The government sells bonds and promises to pay the purchaser a fixed percentage.  In the original scam, the company produces more shares, so the one who purchased stocks gets less dollars when the dividend is paid out.  So how does the government perpetrate this scam? Instead of issuing additional stock and thus giving the investor less dollars, they just issue additional dollars, which dilutes the value of the dollars that they owe.  The net result is no different.  Both groups of investors receive dollars that have less value to purchase goods and services than they anticipated when they entered into the transaction.

This is not a theoretical concept that may or may not play out in reality.  This is exactly what is happening in the United States right now.

This is a graph of the money supply in the US.  This may look too crazy to be real, but it is reality.  The amount of money injected into the economy in the last 14 months dwarfs all of the money creation in the last 60 years combined.  Meanwhile, while the treasury is printing money, the Federal Reserve is manipulating bond markets to keep interest rates artificially low.  What is the result? Those holding bonds are being paid with dollars that are being systematically devalued.  This is easily illustrated in the chart below.

This is year to date inflation compared to the interest being paid on 1-year T-Bill issued by the Government.  What this means is that if you buy this bond and loan the government $100, they will give you $100.05 in a year.  However, they are also creating a system where a dollar has lost 4.16% of it purchasing power in a year.  Stated differently, you will need an extra $4.16 to purchase the same bundle of goods and services that you bought for $100 one year ago.  So to recap, by investing in this bond, you begin by having $100 which can purchase $100 worth of goods and services.  One year later, you have $100.05 to spend, but those goods and services now cost $104.16.  This is a GREAT deal…for the government.  For one holding bonds?  Not so much.

The real problem, however, isn’t one-year bonds.  These bondholders will get their principal back at the end of year and get to reinvest it.  Eventually interest rates will reset to price in inflation, and losing a little purchasing power for one year won’t hurt too much.  The real hurt will be for those owning longer-term maturity bonds.

Right now, those that are willing to loan the government $100 for 20 years are agreeing to only getting $2.19 per year in interest for the next 20 years!  We saw how in just one year of 4% inflation, the purchasing power of a dollar can erode pretty quickly.  Even if we only see increased inflation for a few years, and then we return to the historic norm of 2-3%, that will be enough to have devalued this $2.19 payment a considerable amount; enough so that the bondholder will see a significantly negative real (inflation adjusted) rate of return of the course of 20 years.

This “scam” will likely have a massive impact on bondholders, who will be left holding the bag for the $23T debt the government currently owes by unknowingly agreeing to take pennies on the dollar on what they are owed.

So what is an investor to do in this unique circumstances?

1.) Avoid long-term maturity bonds.  Do not commit to receive an interest payment less than that of inflation for a long-time period.

2.) Reduce your bond exposure in general.  Bonds are very important as a diversifier in an investment portfolio to smooth returns and provide safety at times when the stock market is declining. However, many people overestimate the amount of safety they need to mitigate the equity risk in their portfolio. For some investors, an increased exposure to stocks can actually decrease their overall portfolio risk. This is something that would be good to discuss with a knowledgable adviser.

3.) Hedge inflation by using treasury inflation protected securities (TIPS) as a substitute for traditional bonds.  These bonds reprice with inflation each year, so will never lose purchasing power as a result of an inflationary increase.

4.) Look elsewhere for safety.  There are options offered in the insurance and annuity world that can potentially act as a bond substitute that may not have the same level of exposure to inflation risk.

Planning and advisory services provided through Keystone Wealth Partners, LLC , a  federally registered investment adviser under the Investment Advisers Act of 1940. Registration does not imply Information a certain level of skill or training.  More information about Keystone can be found by visiting www.adviserinfo.sec.gov and searching by the adviser’s name. This is prepared for informational purposes only and may not be applicable to your particular situation or need(s). It does not address specific investment objectives.  Information in these materials are from sources Keystone Wealth Partners, LLC deems reliable, however we do not attest to their accuracy.  Past performance is not indicative of future results.

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