In this post, I want to discuss US Treasury bonds and how inflation can impact these bonds.
I have decided to split this post into three segments:
- In the first segment, I’m going to discuss what US Treasury bonds are.
- And in the second segment, I’m going to discuss about inflation and how it will impact US bonds.
- And finally, I’m going to show you that you probably own US bonds indirectly already, although you might not be aware of it.
US Treasury bonds
US Treasury bonds are debt securities issued by the US government. Therefore, whenever you are buying US bonds, you are lending money to the US government. The US Department of the Treasury issues these bonds to fund the operation of the US government. This is how US bonds work.
This picture shows that first, investors would lend money to the government by paying a principal to purchase the US bonds.
Second, the government pays the semi-annual bondholder coupons based on a fixed interest rate during the lending period.
And Third, after the end of the lending period when the bond matures, the government returns the principal to the bondholder.
The government gets to use your money during that period and compensates you by paying interest every six months. As you can imagine, the yield or return on your investment as a bondholder is very much dependent on the coupon rate or the interest payments you receive during your investment period.
A higher coupon rate is more desirable as it increases the cumulative payments you would receive by investing in US bonds. Therefore, the simplest way of evaluating the yield or return on investment for US bonds is to look at their coupon rates.
Note that there are multiple defining yields for US bonds, and some are more complicated than others. But, for the sake of this analysis, we are just going to stick with this simple definition. The yield rate for 10-year US treasury bonds is somewhere around 1.5%, meaning that when you lend the US government $100, you will receive $1.50 each year for the next ten years.
At the end of the 10th year, you will get back your principal investment of $100. The question we should ask is, “is this a good investment”? And the answer is no. These are some crazy low yield rates. To appreciate how low these rates are, let’s take a look at the inflation rate in the US.
Inflation rate in the US
Inflation is the general increase in price levels. Alternatively, inflation is defined as the decline in the purchasing power of the currency over time. In other words, in an inflationary environment, the purchasing power of the money you have today will be lower next year.
Note that inflation is a bond’s worst enemy. Inflation erodes the purchasing power of a bond’s future interest payments. US bonds have fixed coupon payments. Therefore, the interest rate you receive will not change over time, even when inflation goes up.
The average US inflation rate during the past few years has been somewhere around 3%, according to the Consumer Price Index (CPI) posted on the US Bureau of Labor Statistics website. An inflation rate of 3% means that the Dollar is losing 3% of its purchasing power every year.
That is to say, today’s $100 will be able to buy you only $97 worth of goods next year. Therefore, the real value of your $100 is going to be $3 lower next year compared to this year, even though its nominal value is still going to be $100.
Now, it would be interesting to layer in this 3% annual decline in the purchasing power of your money on top of the previous chart. If you invest your $100 in US bonds, the government will pay you $1.5 annually in the form of interest rates.
On the other hand, your $100 principal will lose 3% of its value to inflation. Therefore, in aggregate, your principal is going to lose $1.5 of its value every year. Link, The bottom line is that under current circumstances where US bond yields are below the inflation rate, investing in US bonds is a crazy idea.
US bond yields, shown in GREEN, have been steadily dropping over the past 35 years, as shown in the chart. As discussed earlier today, the 10-year US treasury yield shown in RED is below the inflation rate. Meaning that your US bond investments are losing value over time.
Things might change in the future, but investing in US bonds is not a great idea. Note that this was not the case back in the day when US bondholders would make decent returns because US bond yields were higher than the inflation. How fast you lose money on US bonds depends on the gap between their yield and the inflation rate.
You already own US bonds.
Well, you might argue that I have not invested in US bonds, so why do I care? However, you probably indirectly own some US bonds through mutual funds or ETFs you have invested in. For example, if you have a 401K account and use their default investment plans, usually target-date funds, you own US bonds.
Target-date funds are mutual funds, or exchange-traded funds (ETFs) structured to grow assets for individuals who plan to retire at a specific time in the future —hence, the name “target date.” For example, if you plan to retire in 2040, you could invest in 2040 target-date funds optimized to meet the capital needs of investors who want to retire in that year.
These funds always allocate a percentage of their assets to US bonds. Therefore, if you are investing in target-date funds, you are indirectly investing in US bonds. Note that you do not have to stick with your default 401k investment plans. You can always choose your investment plans such that they deliberately exclude US bonds.
My suggestion is that instead of using the default plans offered to you by your 401k plan provider, you should take control of your account’s asset allocation. Ensure that the ETFs and mutual funds you invest in do not allocate a large number of their assets to US bonds.