“Return-Free Risk”

Jim Grant, in a great interview last month, described investing in government bonds as “return-free risk” (quoting a friend). Let’s examine something I learned back in Economics 101:

Nominal interest rates include the real rate of interest plus inflation. For example, if interest rates are currently 5%, then we can subtract inflation to figure out the “real interest rate” from the nominal. If inflation is 3%, then the real rate is 2% – understand?

Here’s  the problem with government bonds today. If a 2 year bond yields below 2%, and inflation is running much higher than 3% (don’t believe government data), then what is your “real’ return for owning these things? It is NEGATIVE. On an after inflation basis, you are losing money each year even though you are earning interest.

How does this work? Pretend you have $500 in a bond. And also pretend that currently that bond pays 2%. Let’s also pretend there is 5% inflation and that currently, a cord of firewood costs $500. You decide to put away $500 in something “safe” to buy your firewood, a 2% one year bond hypothetically. Here’s how you ‘lose’ money:

Your $500 grows to $510 in one year in the bond. The Firewood, however, increases in price by 5% to $525. Now, in order to buy the wood, you need your $510, plus an extra $15 from another source. Through this inflation, you lost money. This is the new conundrum – why markets are accepting negative real rates of return (2% nominal – 5% inflation = -3% real return) is beyond me. Perhaps people are so scared of stocks, that negative real returns are more attractive to them?

Bottom line, the Fed will at some point lose the bond market entirely, and rates will rise regardless of their policy. Then you will finally see the full effect of the pain coming – massive asset revaluation, and potentially more foreclosures than any government program could ever stop. At that point, savers will finally earn a decent risk-free yield.

Here’s the interview FYI:

Jim Grant on Bloomberg 

Here is the BLS page on what the government says is current inflation (4%)

BLS.gov 

Jim Rogers has repeatedly said get out of the dollar. He believes the government has been manipulating inflation data for some time. Compare the inflation reported on the above site to what you are paying for things – is inflation only 4%?

Chris Grande

4.13.08

  • Boston AL

    Yup. Makes no sense. From my perspective it seems to be an “emotional” behavioral issue for us humans. This same thing happened in Japan after the economic collapse of the 1980’s. People invested in negative or zero return bonds and bank accounts. (Unfortunately the Japanese economy was not “open” and the average person could not invest outside the country. Nor were there “Inflation-Indexed” bonds available.) Thankfully, “Mr. TIPS” has a solution for people here… I-Bonds! You may not grow rich at a 1% Inflation plus return rate, but at least you will not lose buying power. That and “hedge” investing are good solutions. Ex: If you are concerned over Medical or Energy prices, invest a small percentage in them (5% – 10%). At least you should be able to cover your personal cost increases should the threats rapidly increase.

  • Good points Al…I do worry though about who “creates” that inflation number and whether you would get as much ‘inflation’ protection as you should when the fox controls that number…

    Chris