Tuesday, October 27, 2009

More on Bonds, with Insights from Bill Gross

In Midnight Candles, PIMCO's Bill Gross says what EBR has been saying all year, which is that virtually all conventional financial instruments are overpriced in aggregate: stocks, bonds, and cash. PIMCO presents an interesting analysis that comes to the conclusion that all paper "wealth" in the U. S. is in aggregate overvalued by 100% vs. 50 years ago. Without getting quantitative, I agree. That's the underlying why gold has made sense to me all year. The authorities are making heroic efforts to keep the paper ship afloat. His brief missive is worth a read, philosophizing about getting old notwithstanding, especially when one looks at his photo on the Web page and realize that it took some serious plastic surgery for a 65-year old to look like that.

Specifically because all classes of paper "wealth" appear overvalued, it continues to make sense to yours truly to run with the hypothesis that a Japanese solution could be in our future: very low inflation for long enough to allow Treasury rates to drop further or at least to stay where they are, thus allowing banks to make money on their "carry trade" and allow the Fed to dispose of all its Treasuries and mortgage-backed at no worse than breakeven. The Fed is notoriously stingy and does not like to lose.

In the prior post, we discussed some rationale for Treasuries: if the underlying principal is no good, then we have bigger troubles, and one could at least own gold (and canned goods?).

For retirement accounts, owning a no-current income Treasury can make a lot of sense. This "zero coupon" or "stripped" par bond is purchased at a discount to the ultimate payback price of 100. The rate is computed by a simple compound interest program. A price of 50 for the zero coupon bond will give a higher rate of return the sooner it is paid off at 100. There are three benefits of the zero coupon bond. Here are the advantages:

1. No reinvestment decision with small amounts of interest (at today's rates). If you spend $10,000 to purchase a 4.5% 30-year standard bond at par, every six months you will receive $225 dollars. Try reinvesting that!

2. If rates drop, the mathematics of the bond mean that the price moves up faster than a standard bond that provides current income. So, a "zero" can be bought with the possibility of speculation in mind.

3. Stated yields are about 10% or more higher for zero coupon Treasuries than for par bonds; i.e., a 3.5% standard Treasury bond rate (which is what the media report) is often correlated with a 3.85-4.0% rate for a zero. Why is that? One reason is that it just is that way; the other is the following disadvantage of zeros:
The built-in appreciation is taxable even though one receives no current income. So more people only buy them in tax-deferred accounts.

This can be avoided by finding zero coupon municipal bonds. Another way to avoid this is to find a mutual fund that owns zeros on behalf of fund owners; but yield to maturity is notably lower with these vehicles than with bonds you directly own. American Century is the fund I use; one security of theirs to look at has the symbol BTTRX.

Strangely, the standard bonds that pay interest every 6 months are much safer should interest rates soar than are zeros. Let us say that you buy a 10-year Treasury and rates soar from 3.5% to 20% in one year. Yes, the market price of both bonds will plummet. If you invested $10,000 in a standard bond, you will receive $350 per year. If interest rates go to 20%, you at least can earn $70 per year off of that $350 (excluding taxes). It's not a lot, but that extra $70 can compound at very high interest rates for the life of the bond. With a zero, the value can go near zero.

Zeros are also less liquid than standard par bonds.

Overall, the less well-known zero coupon bonds are the simpler, higher-yielding bonds that also offer better profit potential should rates drop a lot. The path less taken in this case is the better one for people who do not need current income and are confident that they can afford to hold the bond till maturity.

Zeros are one way that yours truly is dealing with the highly abnormal financial environment.

Copyright (C) Long Lake LLC 2009

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