|
|
Inflation/Deflation and US Gov BondsJul 26 '03 Write an essay on this topic.The Bottom Line Consider inflation when investing in US Gov Bonds, it has been discounted (IMO) too much. In Summary Inflation has been a now forgotten risk to many investors; but ultimately it is one of the greatest risks to savings/investments. The article will explain what inflation is (in basic terms), what deflation is (in basic terms) and how each of these tends to affect traditional bonds and equities (stocks). Inflation and Deflation, a Basic Look Inflation in essence is when a dollar (of whatever currency) is worth-less today than it did yesterday. It does not mean that the currency is “worthless” it is just worth-less. In real life terms this means that something that cost a dollar yesterday now costs a $1.10. It takes more money to buy the same product or service. Inflation for the consumer can be measured in many ways but the most popular way is the Consumer Price Index or the CPI. Other measurements (notably the Gross Domestic Product Deflator) have become “more important” in the eyes of some key policy makers (notably Chairman Greenspan) but the CPI is still considered the “authority”. Deflation is the exact opposite, it is when a currency gains in value against product or services – what cost a dollar yesterday now costs only 90 cents. It is also measured by the CPI. Affect of De/Inflation on Traditional Government Bonds Higher than expected inflation tends to raise the interest rate on government bonds; this is because people demand a “real” return on their investment. People do not want to just “break even” in terms of purchasing power, they want to make a “real” return. You can figure a basic “real” return as Nominal Return – CPI rate. For example; a 4% bond yield – 2% inflation rate puts the “real” return on investment at 2%. Because there is an inverse relationship between price and yield (take a look at my other article on US Government Bonds) inflation tends to lower the prices of bonds and raise the rate of return on bonds. Deflation on the other hand has a tremendous positive affect on the price of government bonds. This is because of the following. 1) Government bonds yielding anything above 0% suddenly have a “real” return equal to the deflation in the economy and because, 2) Deflation tends to be retched on private company balance sheets, and people flee private companies for the safety of government bonds. Private company bonds will also be raised in price; however, the rise will be confined to companies not already under tremendous debt burden. This is because deflation increases the “real” debt burden on companies. Debt service payment (interest payments) start to take larger and larger chunks of the otherwise declining revenue stream and it becomes very difficult for the company to manage, especially if it is in high debt already. Inflation/Deflation’s effect on Stocks Inflation does two things to stocks; first, it tends to lower the price earnings multiple of companies as the “earnings” portion rises (assuming a steady level of prices in the market). Inflation also “erodes” the real burden of debt for a company, strengthening the balance sheets of those companies. Deflation hurts stocks because it has the exact opposite effect; it increases the debt burden and increases the PE ratio (assuming steady prices again). “Winners” and “Losers” In Each of the Following Scenarios 1) Higher than Expected Inflation – Winners - Those with high debt burdens, those who have stocks/junk bonds. Losers – Those with savings that pay fixed, non inflation linked rates. 2) Lower than Expected Inflation – Winners – Those who hold fixed interest rate vehicles. Losers – Those with high debt burdens who were counting on inflation to eat away debt. 3) Persistent and Significant Deflation – Winners – Holders of government bonds. Losers – Basically everyone else. Warnings Beware if you are holding longer term government bonds; the “expected” rate of inflation for the 5 year, 10 year and even 30 year bonds are VERY low and assume a Federal Reserve that has not only conquered inflation but a Fed that would allow deflation. Because deflation would wreak havoc on our banking system the Federal Reserve is unlikely to let it happen. Those who have recently moved into longer term government bonds should seriously consider the implication of anything more than a minor inflation rate (currently the expectation from the market for 10 year average inflation is a mere 2% per annum) on the “real” value of their savings. They may be caught by a VERY nasty surprise when/if inflation takes off and the “real” value of their bonds decline. On the Other Hand As always, there is always the “other hand” if I am wrong the market may be signaling the coming of a deflationary cycle (according to the bond markets) or an inflationary one (according to the equity markets as of late). Conclusion Inflation has become too discounted; this might lead people to buy government bonds when in reality other investments are likely to do better. It also means that people might find out too late that the retirement nest egg they thought so adequate has been eroded by inflation. Recommendations This is quite a self serving recommendation – but my other articles sort of go deeper into some specific things that I mention here. Check them out. As always, please leave your thoughts/comments.  |
| Read all comments (2)|Write your own comment |
|
Ads by Google
|
