By Professor Rick Ulivi, Ph.D.
Most of us like to make money, and certainly most of us enjoy spending it.
We can make money by working or by investing our savings. Savings result from money we worked hard for and chose not to spend. When it comes time to invest, we like to be very cautious with it—because it took so much effort to acquire it in the first place!
Our traditional options for investing are to leave it in the bank and earn a low rate, put it in stocks and pray that they go up, invest in real estate and hope we won’t get the tenant from hell, or lend it. Yes, lend it by way of buying a bond. It would seem that if you are lending you are not buying, but that’s finance for you!
Should you be investing in bonds right now? The answer depends on your prediction of interest rates. If you believe that rates will go up significantly in the near future, don’t buy bonds now. That’s because your bond’s market value will drop because its price will move inversely with interest rates. So, if rates go up, bond prices go down. On the other hand, if you believe that rates will go down, you should definitely buy bonds now because you will lock a higher interest rate than others will be getting in the future, plus your bonds will go up in value.
What should you do if you believe that rates will continue to stay low and not move much in the near future because of the Fed’s promise to keep rates low? Buy bonds. That because you will, at least, earn something, which is better than the zero returns banks are paying.
However, buying bonds today creates a risky position. That’s because current interest rates are way below the historical inflation rate, and this is not sustainable. The average historical inflation rate has been around 3%, yet if you lend money today to the US Government for 10 years, it will pay you a meager 1.67% per year. That means you are losing purchasing power—which is the one thing you always want to maintain.
What happens if interest rates go up suddenly, to compensate for the loss of purchasing power? The value of your bonds will go down and you will have lost money. How much? Let me illustrate this with an example.
The 7-10 year US Treasury bond fund sponsored by iShares has an average yield to maturity of 1.29%, but a duration of 7.4. This means that buying this fund or similar bond lets you earn 1.29% per year for the next seven years, which is a lot more than the zero you would be earning by leaving your money in cash. But let’s look ahead. Suppose that in 3 years interest rates jump to at least the historical rate of inflation or 3%. In this case, the market value of your bonds would drop by about 4.3% (the expected duration times the increase in interest rates). In sum, in three years you made a cumulative 3.9% in interest income (.i.e, 1.29% per year) but you would have lost 4.3% in market value. Adding all this results in a net loss to you of nearly ½%, which means you would have been better off leaving your hard earned money in cash rather than buy bonds today. Imagine if rates were to go up higher than to 3%. Anybody remember when mortgage rates were 12.5% and higher?
What happens if you do not buy bonds now and leave the money in the bank? You earn zero. So it would seem that you are better off to buy bonds paying, say 1.67% for ten years, than to earn nothing. Right? Perhaps. Remember, the key is to predict future interest rate movements. Personally, I am pretty convinced that rates have to go up in the near future, regardless of what the Fed is doing or says it will continue to do. Why do I assume this position? Because I don’t believe in fairy tales.
Money has always been a scarce commodity, so it should be expensive to get. Therefore, rates should be substantially higher than they are now. Let me walk you through my personal experience with the cost of money. When I bought my first condo in Argentina, in 1974, I paid 60% interest. (That’s right!) When I bought my first house in the US, in 1979, I paid 12.5% for a mortgage. I paid the same rate in 1985 for a 15 year mortgage on my current house. Yet last July I was able to take out a new loan for 30 YEARS at a fixed rate of 3.5%. Isn’t it crazy that someone is willing to lend me money for that long at that rate? There’s more. Last week I bought a new car and took out a five year loan, with zero down. Do you know what rate I got? 1.78% per year. The moment I drove out of the dealership that car dropped 10% in value, yet a bank was willing to lend me money for basically nothing, and with no equity in the deal. This cannot be sustainable. Rates have to go up to at least match the historical inflation rate
The great opportunity right now is to BORROW money, not lend. If I were younger, I would be borrowing like crazy—like I did when I was younger. But at this stage of my life, financially speaking, I am mainly interested in cash flow, not rate of return.
In sum, as of today, I do not recommend buying bonds because rates are too low and the financial mess Washington is in points to higher inflation than today. But I am always very aware that I could be wrong, and that buying bonds now would have been a great opportunity. I am not infallible.
The end of the year is close. I wish you a healthy, loving and profitable new year. If you come across someone who is about to retire and needs some sound investment and retirement advice, please tell them to call me at 714.771.6000 or reply to this email. I would love to help your friends achieve their vision for retirement.