HELPING PHYSICIANS ATTAIN FINANCIAL SECURITY
By Robert M. Doroghazi, M.D., F.A.C.C.
Treasury Inflation Protected Securities:
(TIPS)
The two main risks with any bond (loaning someone your money) are credit risk and interest rate risk. The former refers to the ability of the bond issuer to repay. The higher their creditworthiness (the more likely you will get your money back), the lower the rate of interest they must pay.
Interest rate risk refers to future interest rates. Rising interest rates cause bonds to lose value. No one will buy your 4% bond at face value when rates on comparable contemporary bonds are higher. Your bond has lost value. Inflation causes interest rates to rise, and thus hurts bond holders, because your bond is being repaid with cheaper, sometimes far cheaper, dollars than were lent.
To attract investors who remember the 1970s, and thus fear inflation, to help mitigate the interest rate risk, the Treasury now offers TIPS. The Treasury determines the coupon (interest rate) on the bond. For the most recently-issued 30-year TIPS, this was 2.125%. The inflation adjustment occurs by the Treasury adding the yearly change in the Consumer Price Index (CPI) to the principal of the bond.
This is how TIPS work: the principal is adjusted semi-annually and the interest rate is applied to the adjusted principal. All Treasury Bonds are issued in multiples of $10K. In our example, say the CPI increased by 2%. At the end of the first 6 months, the investor would receive an interest payment of $106.25 (1/2 of 2.125% x $10K) and the principal of the bond would be adjusted to $10,100 (1/2 of the 2% x $10,000=$100).
At the end of the next 6 month period, the interest received would be ½ of 2.125% x $10,100=$107.31, and the principal would be adjusted up to $10,201.
Now, let’s see what the return is in real life for loaning your money to the government. As discussed in a recent letter (Interim Bulletin #165A, 6/11/11), the “intrinsic value of money” (the return you can expect money to generate in a perfect no-inflation environment) is 3-4% per year. The coupon of 2.125% is 1-2% lower than the return you should generate from your money.
The official CPI is determined by the government. Since the adjustment to the principal of the TIPS (and Social Security payments, and many other government obligations) is tied to the CPI, the government has every incentive (both financial and political), an obvious conflict of interest, to minimizing the CPI. As stated many times, I have seen well-reasoned articles which document to my satisfaction that the CPI has been underestimated by at least 3% per year for the last decade.
As they say on some TV commercials: “But wait, there’s more”. Almost no one buys Treasury Bonds and Bills directly; almost all invest through a bond fund. Thus add in the fund’s management fee of at least 0.5%, basically a quarter of your already meager interest rate (this is just one more reason I don’t like bond funds).
To continue with the TV commercial analogy, they will often end with “Operators are standing by. Call within the next thirty minutes, and you will also receive”—a tax bill. The interest is taxed, and the addition to the principal generates taxable “phantom income” (you have received income but you haven’t received the cash to pay the taxes).
In the above example, you lose 1-2% per year by the coupon rate being less than the intrinsic value of money, 3% by the government fudging the CPI numbers, and ½% to the bond fund management fee. By my estimation, the money you loan the government via TIPS results in a 5% loss per year in purchasing power. Then you must pay taxes. I submit the allure of TIPS is an illusion. Don’t loan your money to the government: they make the rules; they can change the rules, and never to your advantage. You can not win. You will not win.
If you want some real inflation protection, buy gold.
RMD
I would like to thank the people at Central Trust here in Columbia for taking the time to answer my questions on some of the finer points of TIPS. I am not embarrassed to ask for help, especially when it involves my money.
The market was crushed last week, and after the close on Friday, Standard and Poors downgraded the debt of the United States of America from AAA to AA.
1) I again remind you; we are in a bear market in financial assets and a bull market in hard assets that began in 2000, and I believe still has 5-8 years to run.
2) If you have held stocks over this time period, after factoring in taxes and inflation, you are down. Eleven and one-half years of dead money. Buy and hold is a myth.
3) Less than 3 weeks ago, the DJIA was 12,750 and gold was $1,600. It took 8 oz of gold to buy the DJIA. Now it takes only 6.7 oz. The DJIA has lost 15% of its value in comparison to gold in less than 3 weeks.
4) On Tuesday, I sent an Interim Bulletin, noting that the Dow was down 8 days in a row. The market usually rallies after such carnage, but I also noted that the weaker the market, the less likely it was to rally.
On Wednesday, the market eked out a token gain of 29 points, it collapse 500+ points on Thursday, and on Friday at one time was up 170, then down 260, then closed with a minimal gain of 60 pts.
This market is so fragile. Considering the terrible weakness last week, the inability to rally, and now the downgrade of US debt, Monday has the potential to be truly ugly. I sincerely hope I’m wrong, but please be careful.
Wall Street Journal 8/4/11). “Buying foreclosed homes as investment properties has long been dominated by mom and pop investors. But now hedge funds, private-equity firms, pension funds and university endowments are dipping into that market. The attraction is double-digit returns”.
RMD comment: Say in 2006, the top of the real-estate bubble, a $200K home rented for $1,100 per month. The expenses were $100/month, so the NOI (Net Operating Income) was $1K/month=$12K per year, giving a capitalization rate (return) of 6%.
During a recession/depression, prices drop until they finally become attractive; people start to buy and the next business expansion begins. If the price of the above home drops to $120K (a 40% drop, as has already occurred in some markets), and the rent stays the same, a NOI of $12K/year provides a capitalization rate (return) of 10%. Now the home is a solid investment.
1) The profit on an asset is made when it is purchased, not when it is sold. If you can generate a 10% return from real estate, it is a buy.
2) Our economic problems will not end until the government gets out of the way, stops manipulating the system, and allows prices fall, to reach the level where they are again a solid investment. Their response to everything so far has been to print money. The result has been to delay the final resolution, and make it more painful.
WSJ (8/5/11). “Bank of New York Mellon on Thursday took the extraordinary step of telling large clients it will charge them to hold cash”.
In an editorial the same day, the Journal said they thought this was the most important event of the day, even more important than the 500 pt. drop in the DJIA.
RMD comment: For some time Barron’s Roundtable members have been cautioning that the financial crisis could become severe enough that there could be the imposition of capital controls, i.e., you might not have total access to and control over your money.
This was just one bank’s policy; capital controls are government-imposed. But it is worthy of your notice, and something to think about.
This is the 3rd of 4 installments of the letter I received from a new physician subscriber:
“I appreciate your advice about not hiring people to do all of your housework, landscaping, etc., on the premise that a physician’s time is too valuable (see Issue #152, 4/11/11, “How Much is Your Spare Time Worth?”). We are a two-physician family and many women have advised me “hire everything done”. We are in a position to do that, but your advice makes good sense. I am determined my daughter and son will both know how to cook, clean, and mow the lawn. How will they learn if they don’t see me do it? My dad paid me the minimal wage to work for him on our cattle ranch. I still equate $60 with 10 hours on an open tractor in 90 degree heat in the hayfield. Any advice you can pass along about raising the children of doctors so they are wise and frugal with their money would be appreciated”.
RMD comment: That’s easy: Just keep doing what you are doing.
George Washington had no biological children. From everything I have read, he was an excellent father to his stepchildren John (Jack, died at age 27, in 1781), and Martha (Patsy, died at age 17, in 1773). Washington tried to make Jack into an upstanding, responsible adult, but he turned out to be lazy and insolent. Washington was able to give J
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