The Bear’s Lair: Riding the tides of interest rates

Much has been written about the end of the bond bull market of 1981-2021 and the return to higher interest rates in the future. In this environment, conventional long-term bonds are a poor investment – their value is eroded by inflation and their prices will fall if interest rates rise. However, there is now an alternative, available in large quantities: Treasury Inflation Protected Securities (TIPS) and their equivalent in Britain and several other countries. Their pricing eccentricities have only recently established themselves, and there are some investment rules that may be helpful.

Investment in bonds requires different skills from investment in equities. Their maximum return is capped (either nominally or in real terms, depending on the bond) so there is no point in taking extra risk. By and large “junk bonds” are highly manipulated by the less scrupulous investment banks, and so with their limited upside potential they are a thoroughly poor investment.

Emerging market bonds suffer from the same problem as corporate junk bonds; there is also an additional risk in that the largest issuers of bonds are the most indebted countries who are most likely to default. Thus the weightings in the J.P. Morgan Emerging Market Bond Index (EMBI – Nasdaq:EMB) include large amounts of credits such as Mexico, Turkey and Brazil (and before 2022, Russia) – poorly run countries with poor growth prospects. Conversely, the emerging market stock index (Nasdaq:EEM) is most concentrated in China, India and Taiwan all countries which, whatever your view of them, have prospects of rapid growth.

Both junk bonds and emerging market bonds also have interest rate risk, to a somewhat greater degree than government bonds since it can come from two sources: a credit squeeze or a rise in interest rates (which may of course be related). The price of EMBI, for example, has fallen by 25% since August 2021, not because of any great surge in emerging market defaults, but simply because interest rates have risen, causing long-term bond prices to decline.

Bond buyers should therefore concentrate their investments in highly rated bonds, say A and above, whether government, corporate or municipal. The differential between Treasury bond rates and corporate bond rates fluctuates according to money market conditions and investor sentiment. At present, 10-year corporate bonds rated Baa by Moody’s, with a significant default risk, yield only 1.72% above Treasuries; this is close to the lowest differential since the early 1990s, according to the St. Louis Fed database, strongly suggesting that you should prefer Treasuries.

Even for AAA-rated corporate bonds (of which there are few) the spread above Treasuries is only 0.69%, again close to the early 1990s low, although corporate AAAs yielded less than Treasuries for a time in the early 1980s, when Morning in America made corporate credit much loved. You should also be aware that today’s AAA-rated corporation is tomorrow’s victim of a takeover or worse still a class-action lawsuit, pushing its credit rating firmly into the “junk” range or even making it default as in the case of Johnson & Johnson. All in all, the government is a mediocre credit and you certainly should not put all your money there, but it probably beats the U.S. corporate sector.

Let us therefore focus on Treasury bond investment. Short-term Treasury bills are at present quite a good investment, yielding around 5.3%, or say 1.5% above inflation, which is more than you can usually get with that degree of almost-complete safety. The problem is the reinvestment risk. If, as many people expect, the Fed forces down interest rates in 2024, then Treasury bills will no longer yield 5.3%. Furthermore, with the Fed reducing interest rates, it is likely that inflation will trend back upwards again; pretty soon your apparently secure yield on Treasury bills will fall below zero in real terms – in other words you will be losing money.

There is also the problem of tax. The interest on Treasury and corporate bonds is taxed by the Federal government at 28% or more; in addition, corporate bonds are subject to state tax, which these days can easily add another 8-10%. Those modestly positive real returns on short-term bills can thus quickly turn negative. You cannot solve this problem with municipal bonds; even the longest top-quality municipal bonds yield less than 4% and out-of-state municipal bonds are subject to state income tax (but look at them if you are in a state without an income tax, like Florida). As for New York munis, which avoid New York state income tax; given the way New York state is run, no thank you! – I would say default in the next decade is more than a 50-50 proposition.

Long-term Treasury bonds currently yield 4.25% for a 10-year bond and 4.45% for a 30-year bond. That is above the current rate of inflation – just – and if rates come down in 2024 long-term bond prices would rise, which is nice. There are two risks. First, long-term Treasuries are a truly lousy hedge against inflation; if inflation takes off, not only are the annual payments and the principal worth less, but the bond price will drop in nominal terms. My Great-Aunt Nan held her savings in 3.5% War Loan (a perpetual bond) after World War 2; by the time of her death in 1974 the bonds were trading at 25% of par, and the value of her pounds had declined by three quarters – so all told, she lost 15/16 of her money. The standard recommendation of a 60/40 portfolio, with 40% in long-term bonds is thus rubbish; it exposes you to far too much inflation risk – even worse if you had adopted it two years ago, when long-term bond rates were below 2%.

That brings me, finally, to TIPS and their British equivalents. These pay interest twice a year, with an inflation uplift that is paid when the bond matures. This makes them attractive for tax purposes; you are receiving only a small taxable income each year, with much of the return deferred into the future, and then taxable only at capital gains rates. It should be noted that this advantage does not apply to mutual funds specializing in these instruments, which pay distributions each year based on the income and inflation adjustments received. Since individual bonds will definitely be redeemed at par plus inflation on a definite date in the future, they suffer less price uncertainty than the funds, which are invested in a mix of bonds that changes from time to time according to the fund manager’s whim and can produce capital losses year after year as the portfolio is foolishly adjusted. One final tax advantage: in the U.S. if you die before maturity of the bond, all the capital gain (from inflation or otherwise) to the date of your death is forgiven, so your heirs owe tax only on gains from your death onwards.

Since Britain had a free-market Gold Standard economy with perpetual government bonds from 1717 to 1797 and again from 1819-1914, you would think we would have a good handle on how TIPS would trade in various different economic conditions. After all, TIPS are supposed to give protection from inflation, just as the Gold Standard undoubtedly did. New gold discoveries, notably California/Australia in 1849-50 and South Africa/Yukon in 1895-97 produced sudden spurts in the gold supply that were inflationary, but since population and output were expanding throughout the 19th century, those spurts were temporary; British price levels in 1914 were below those in 1819.

On the other hand, TIPS are linked to a U.S. consumer price index that can be fiddled; the “hedonic pricing” adjustment of 1996 has made it underreport true inflation by about 0.8% annually, while the British inflation-linked bonds are now linked to a “consumer price index” whose rise magically averages around 1-1.5% lower than that of the Retail Price Index to which the bonds were originally linked. Thus, TIPS and British inflation-linked bond yields should be around 1% above Gold Standard bond yields, to reflect the imperfections of the price indices; they are not.

From the last 40 years’ experience, TIPS do not behave like gold standard bonds. The lowest ever yield on Consols was 2.2% in 1897, whereas the TIPS yield was negative 1.2% as recently as August 2021. In Britain, 50-year inflation-linked “gilts” were sold in November 2021 at a yield of negative 2.39% — in other words, investors were prepared to lock in a negative real yield for half a century. Needless to say, the capital losses on such bonds as real interest rates have normalized have been huge.

‘Why would anyone accept a crazy negative yield on TIPS?’ you may well ask. Two reasons. First, central banks around the world ran a Soviet-style monetary policy from roughly 2011 to 2021, in which interest rates were kept below inflation and far below their equilibrium level; naturally in those circumstances even a negative real yield seemed attractive. Second, British pension funds were forced by exceptionally stupid 1990s legislation to invest in long-term inflation-linked gilts; they consequently drove the prices of those gilts up to economically absurd levels. The pension funds’ near-bankruptcy as interest rates rose was used as an excuse by the Bank of England and others to destabilize the Liz Truss government in 2022 and install “Squishy Rishi” Sunak. Reform of both pension fund regulation and a Bank of England that has descended into vulgar Marxism is urgently needed.

At present TIPS yields are more normal, although the differential between the 10-year TIPS yield at 2.05% and the 10-year Treasury bond yield of 4.26% gives a breakeven average inflation over the next decade of only 2.21%. This is surely too low (given that the Fed’s inflation target, which it periodically overshoots, is as high as 2%) so TIPS are a good deal relative to Treasuries.

The final question when considering TIPS investment is the credit risk. I would never buy 50-year TIPS; the chance of British or U.S. default is horribly high – once the debt to GDP ratio reaches the Japanese level of around 250% the political pressure to default on debt will be irresistible. However, this side of 2050, assuming the U.S. does not keep re-electing President Biden, the default risk is modest – the Penn Wharton Budget Model estimates the U.S. debt to GDP ratio in 2050 will be 188% at “baseline” interest rate projections and 229% if real rates rise 1% above the “baseline.”

Bottom Line: Currently U.S. TIPS yield just over 2% plus inflation. Short-term TIPS (out to 2030 or so) are thus a sound investment, with little price risk – you can buy them in the secondary market through your broker (Vanguard and Fidelity both offer this service) although the price you will pay as a retail investor will be perhaps 0.1% above that paid by the big guys investing more than $100,000 per bond. I advise buying a few of several issues, to spread the maturities and avoid a “lumpy” tax bill.

Longer term TIPS, maturing in the 2040s, are also attractive, especially as most of them, being 30-year bonds issued in the 2010s, have interest coupons of 1% or less and therefore trade at steep discounts. For example, the 0.75% TIPS due February 15, 2045 today trades around 75% of par to yield 2.24%, although “par” is now 1.30695 times their original $1,000 issue price so you will pay about $980 per $1,000 bond to buy them – and get $1,306.95 plus 2023-2045 inflation at maturity. These have an additional speculative advantage that, if the world’s central banks go back to “Soviet” monetary policy and TIPS yields decline to zero or below, you will be able to sell them for a big capital gain, since bond prices will rise to par or above as yields decline.

I hope the above, from an old bond specialist, has been helpful.


(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)