Why Buying Treasuries Is Not A Rational Investment

|
Includes: JNJ, MCD, PG
by: Tim McAleenan Jr.

While there are plenty of definitions of what the purpose of investing may be, for me it is this: the foregoing of consumption today with the belief that the delayed gratification will increase my purchasing power in some future tomorrow.

If I lived in 1950, I would find it foolish to put a $10 bill in an envelope to spend 50 years later. Why is that? Because that $10 could go a lot further in 1950 than in 2000. Using Warren Buffett's hamburger test, you could probably buy 100 hamburgers for $10 in 1950. Today, if we use the McDonald's (NYSE:MCD) dollar menu as our baseline, you could get about 10 hamburgers for $10. This was not a good trade-off: an investment that yields 0% in a world of 3-4% inflation will make you substantially poorer over a long period of time.

In fact, anytime you make an investment where the return is less than the rate of inflation, this statement holds true: you will eventually go broke if the time period is long enough, or the difference between your return and the inflation rate is big enough.

With some frequency, I get asked the question: If you owned a company like Procter & Gamble (NYSE:PG) or Johnson & Johnson (NYSE:JNJ), what would it take to get you to sell? My answer is this: if I can find a better place to put my money, or if Procter & Gamble and Johnson & Johnson grew their earnings and dividends at a rate lower than inflation for a sustained period of time and I did not believe this status would change in the future.

Which brings us to Treasury bonds. For most people, buying Treasury bonds at the prevailing rates ought to be irrational. According to Treasury.gov, the 10-year rate for Treasuries is 1.67%. For 30-years, it is 2.81%. You have to ask yourself the question: Do you believe that the inflation rate will be greater than 1.67% over the next 10 years? Do you think the inflation rate will be greater than 2.81% over the next 30 years? If you answer yes, then it is most likely irrational for you to purchase Treasury bonds. You are guaranteed to lose purchasing power. If inflation is greater than your return rate, you will grow poorer over your holding period. You would get more utility out of spending the money on something else today. And heck, to add insult to injury, you might even be in a situation where you have to pay taxes on your 1.67-2.81% returns. You'd effectively be paying Uncle Sam for making you poorer as your purchasing power slowly decreases.

The only thing that could make a Treasury investment rational would be if you foresee some kind of Japanese-style deflation coming, which seems highly unlikely given the American response to the financial crisis. To put it more concretely, an investor purchasing Treasury bonds for a 10-year duration would only be acting rationally from a purchasing power point of view if he believed that the inflation rate would be 1.66% or less. Likewise, if he purchased 30-year bonds, he would have to believe that the inflation rate would be 2.80% or lower over the next 30 years. Even then, he would only experience a negligible purchasing power improvement.

I am a huge fan of Benjamin Graham. I know that he recommended always keeping 25% of a portfolio in bonds. But at no point did he ever write for an audience that might face an inflation rate that seemed as guaranteed to result in a purchasing power loss as we are facing today. And even if he did, I'd have to ignore that advice on the belief that investments are supposed to make you richer over time, not poorer. And since I see no indication that inflation will be below 1.67% over the next 10 years, or 2.81% over the next 30, then I cannot regard the purchase of Treasuries as a form of wealth-building.

If you accept my premise that the purpose of investing is to delay gratification today in the pursuit of increased purchasing power in some distant tomorrow, then it becomes very difficult to justify the purchase of Treasury bonds as an investment. Since 1987, we have only had four years in which the inflation rate was below 2.0%. And that was when our country was pursuing financial policies that would be less likely to create future inflation than we are currently pursuing today. We have reached the point where holding a Treasury bond to maturity has become a near-guaranteed way to lock in a loss.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.