Ten Year Treasury Note: A Terrible Investment

If you believe Mr. Bernanke, he will soon stop his purchases of under priced debt. Foreign holders have shown only modest interest in new US sovereign exposure of late. Their increases are only in short-term debt instruments. Central Bank holdings of coupon debt has increased by only $50b (June 08 vs. June 09). During the same period the CBs sold $90b in fixed rate Agency paper. If the Fed isn’t buying and foreigners aren’t either it means that Americans are going to have to come to the rescue and buy a great deal of bonds starting at some time in the near future. I can’t imagine why anyone would do that. Treasury coupons are a terrible investment.

If you subtract the current 10-year yield from the ten-year TIP you get an indication of how the market is pricing future inflation. The current difference is 1.66%. I think that is a ridiculous assumption for the next ten years. It will be higher than that. But these are big markets and we have to use what these markets tell us.

This estimate of inflation is also a discount rate to determine future values. For example, if the actual inflation rate over the next decade is 1.66%, then $100 today will be worth only $85.43 when the bond matures. Similarly the interest that is received is worth less. The $3.30 one would get in the tenth year is worth only $2.75. It gets worse.

The Treasury has its hand out when it pays interest. The average marginal tax on unearned income is 30%. So if you buy Treasury paper you only get 70% of the income net of taxes. When taking into consideration the tax impact and the rate of inflation the adjusted return to an investor is just .43% for the current ten-year bond.

If your expectations for inflation are closer to 2% versus the TIPS pricing then you really have to stay away from Government bonds. At a 2% inflation rate the return goes to zero. At 2.5% average inflation the return is negative. For an investor who puts up $100 today they will receive a TOTAL of only $94 in return over the ten-year period.

If one was wondering why junk stocks have a bid, or why PEs are so high, or why gold is pushing $1,000 you just have to look at this calculation. The inescapable conclusion is that for a ‘buy and hold’ investor the very worst place to put your money today is in Treasury bonds. It is just plain stupid.

Mr. Bernanke’s effort to keep rates low through open market purchases has worked. It is hard to imagine what would be happening in the real economy were it not for the QE program. As/when QE ends Mr. Bernanke will learn that no one wants to play in his sandbox any longer. It is difficult to ponder what market conditions will be like when that realization takes hold.

Comments

[Roger Knights:]

"It is hard to imagine what would be happening in the real economy were it not for the QE program. As/when QE ends Mr. Bernanke will learn that no one wants to play in his sandbox any longer. It is difficult to ponder what market conditions will be like when that realization takes hold."

Unless there's a stock market crash, in which case:

there'll be another flight to the safety of Treasuries,
so the interest rate will stay low,
so real estate won't collapse, and
No Bank will be Left Behind, and
the gov'ts. debt can be rolled over and its deficits financed.

For an incredible, mind-warping, way-outside-the-box SA article (of Aug 24) that suggests that this is the game plan of TPTB, see "How to Trade Using Game Theory," here:

seekingalpha.com/artic...

Sep 04 04:59 AM

[Fabien Hug:]

It's the rock and the hard place. I read with great interest this article re game theory but I don't buy the "managed crash" scenario. Private economy needs to get rid of leverage. As long that doesn't happen, no real recovery and no increase in tax income. The best way to quietly get rid of leverage is to keep asset valuations high so that corporations can trade debt for equity. Bernanke is not working alone in this mess.

Sep 04 09:37 AM

[LKofEnglish:]

theory is nice but you have to clear the trade. in other words Bernanke still must "pull off the sales pitch." While I agree bonds are not a buy in here, hats off to Bernanke and Geithner for making them a buy in here. I fully expected interest rates to collapse this summer and needless to say unlike the clown above still "waiting for the inevitible collapse" of the stock market the soaring stock market this summer said to me "bond market collapse" was inevitible not stock market collapse. Instead these finance guys knew what they were doing and off -loaded trillions in treasuries at ridiculously low rates. Gotta love it.

Sep 04 10:23 AM

[paulsjj:]

"Bonds are the house we live in." We (gov) sold the "house" to foreigners.

Sep 04 10:28 AM

[hatarakiman:]

Foreigners(non residents) don't have to pay tax on Government bonds.
People do buy bonds and use it as collaterals. The Margin Maintenance Req of 5~10 year bonds is only 4% market value. You can earn 3.38% plus other derivative's gain.
Assuming you always buy 10 year notes at auction and hold it to maturity, spreading it out, it's like 10% each year for the 10 year notes. It's ok to put 10% in 2008 and another 10% in 2009...
But anyway, I prefer TIPS, it's inflation safe. But if you buy it from the secondary market, it's better to choose the market price that is less than the 100 principal value.

Sep 04 11:07 AM

[Stephen Ros...:]

For those who are not active investors, where would you put your money? Bruce, I am thinking of the average person here. Thank you.

Sep 04 09:47 PM