Friday, June 10, 2011

Long-Term Treasuries vs. Inflation

By Bert Whitehead, M.B.A, J.D. © 2011

The federal government has been grappling with ballooning debt as the cost of government programs and entitlements outstrip tax revenue. Politics will ultimately determine whether to cut spending, increase taxes (or both) to solve the problem. This blog is not political commentary, but rather a response to the media’s concern about how these deficits, and the corresponding debt increases, will impact the financial markets.

Will U.S. Treasury Bonds become worthless?

Historically, the danger of not backing paper money with gold or silver is that governments will spend more than they can afford to repay over the long term. To cover the accumulating debt, the easy solution is to print more money to pay back borrowers. But the result is that the currency becomes inflated and prices rise as the value of the currency shrinks – the result of too many dollars chasing too few goods. The most recent global example of this took place in Zimbabwe, which ended up printing $100,000,000,000,000 bills (that’s 100 trillion dollars) that would buy about $5 worth of goods in US dollars.

History is replete with examples of countries that inflated their currency to the point that citizens insisted on being paid with gold, another country’s money, or else they resorted to bartering. This included the notorious Weimar Republic in Germany after World War I, as well as most South American countries (called “banana republics” because they used locally produced bananas to settle their debts). Even in the U.S. there have been four instances in which the government suspended backing of the US dollar. This resulted in financial panics, probably aggravated the Great Depression, and triggered ‘stagflation’ in the 1970’s.

As dismal as this background is, there is no attractive alternative. The US dollar is well entrenched as the world reserve currency. China and other foreign countries are owed more than half the US debt. But they can’t dump it on the White House lawn and insist on gold…dollars are not backed by gold. They can sell dollars and buy Euros, or Yen, or British Pounds, but those currencies are as bad as the US dollar. The Swiss Franc and currencies of other fiscally conservative countries are not ‘deep’ enough, i.e. not available in sufficient quantities to support world commerce.

How do you protect yourself from inflation?

Many countries (including the US) have significant stores of gold, and this reserve is attractive to many citizens. But now that gold shares can be bought and sold on stock exchanges, buyers don’t have to take actual delivery of the gold. As a result, the price of gold has become very volatile and is probably in a bubble now as speculators trade gold frenetically. I should note that inflation was not offset by the stock market in the 1970’s and the price of gold was basically flat for the 20 years from 1980 to 2000 while inflation increased over 100%.

There is some protection against the falling dollar when you buy mutual funds that invest in international stocks and do not hedge the dollar. We have used this approach for many years to temper the impact of the dollar’s devaluation. As we increase our participation in the global economy, currencies of other countries (many of which are backed by dollars) have tended to track the dollar’s value.

Interestingly, real estate has historically been considered an inflation hedge, but current worldwide prices are either very depressed (as in the US) or have wildly increased (e.g. Canada).

The absolutely best protection against inflation is to have a long-term mortgage at a fixed rate on your home. Many people flinch at the thought, but it is a huge advantage to owe a couple hundred thousand dollars at 5% fixed for 30 years if we see inflation mushroom over the next 5-10 years. Not only will your money market rates increase to 7-10% on money that is costing you 5%, but you are also repaying the mortgage with cheaper money.

The beauty of a long term fixed mortgage is that, if interest rates go down, you can just refinance and reduce your monthly living costs (which protects you from deflation). The worst-case scenario with a mortgage is when interest rates stay the same. Even then, on an after-tax basis, your return is about the same as your cost so it is a breakeven.

Now back to those Treasuries: the trading value of all bonds, including Treasuries, varies inversely with interest rates. So the market value drops when interest rates go up. Interest rates can rise very rapidly during times of inflation. However, we recommend that clients hold Treasuries to assure cash flow in later years, not to maximize yield. My mantra when it comes to bonds is: “Safety Trumps Yield!” Holding on to long-term Treasuries in a balanced portfolio protects you against deflation…which is still a significant danger. Regardless of short-term price moves, hold a Treasury until maturity and you will get your money back, including accrued interest. Your investment is insulated against inflation.

Holding cash in money markets will usually stay even with inflation, since the increase in interest rates will offset inflation. The worst mistake is to try to ‘chase yield’ by always seeking bonds with a higher rate. As Warren Buffet once commented: “People have lost more money chasing yield than they have at the point of a gun…”

At ACA, we use the principles of Functional Asset Allocation and design your portfolio to protect you during times of inflation (using cash and a long-term mortgage on your home). We maintain properly diversified stocks so that you will gain during times of prosperity. And we still recommend that you hold long-term Treasuries to protect you against deflation and assure cash flow during retirement.

I appreciate the editorial review contributed by Chip Simon, CFP®, an ACA colleague in Poughkeepsie, NY.