Economic News & Analysis - March 29, 2012Myths about fixed-income investing
By Brian Jacobsen, Ph.D., CFA, CFP®, Chief Portfolio Strategist
Before we dispel some of the myths surrounding fixed-income investing, here are four facts about interest rates that few people believe:
Myth #1: There is this thing called “the interest rate.”There is no such thing as one interest rate. There are lots of rates. Most people are actually talking about “yields,” not “rates,” but that’s a bit pedantic. The fact is, there are many interest rates out there, some that apply to various types of U.S. Treasury securities of various maturities (that is, time to final payment) and characteristics (some are inflation adjusted, others are not), and some that apply to different issuers. Debt is issued by businesses, municipalities, and individuals, and each type of debt has its own rate. There are commonalities amongst them, but there is no iron law that links the one type of interest rate to another. For example, just because the cost of borrowing of the U.S. federal government rises does not mean that all other interest rates will also increase in a mechanical fashion.
Myth #2: Interest rates cannot go below zeroThe German government, the U.S. government, and the Swiss government have all issued debt with a negative interest rate, so this myth is just plain wrong. If you think about it, it actually makes sense that interest rates can be negative. Think of a checking account. Most checking accounts don’t pay interest, and some actually charge a fee or require a certain minimum balance. A checking account is actually a form of debt issued by a bank. The accountholder—the depositor—lends the bank money but doesn’t necessarily get any interest on the loan. Instead, the depositor receives services from the bank—both in transaction services provided, by virtue of being able to write checks, and also “storage value” for the depositor’s money. In other words, depositors probably would rather have a bank safeguard their money than keep all that cash sitting around. Big depositors might find it more convenient to hold cash at banks instead of in their desk drawers or pockets, meaning banks could pay negative interest rates on deposits to charge for that valuable service.
The central bank—in the U.S., the Federal Reserve (Fed)—could also pay negative interest rates on reserves held at the Fed. Not only is it more convenient to hold a boatload of money at a safe place—like the Fed or in the form of Treasury bills—the Fed could also require banks, in order to operate as a bank, to hold a certain amount on reserve. Sure, the banks might rather hold the money as cash in their own vaults instead of with the Fed, but the Fed has the power to force banks to do its bidding. This means that the Fed could push rates negative. Banks do it all the time with fees on accounts or required minimum balances on accounts.
Myth #3: Interest rates on Treasury securities are predictions of economic growthOne common thing I hear from strategists is that the current yield on 10-year Treasury securities is a prediction of nominal (that is, not inflation adjusted) growth of the economy. This is patently and empirically false. If it were true, then why was the average interest rate on U.S. government debt 4% from 1871 to 1992, while average growth of GDP was 5.9%? It seems that interest rates on government debt greatly underestimate future nominal growth of the economy!
The myth stems from the idea that current yields on government debt are equal to a real yield required by investors and some compensation for inflation over the term of the loan. While this is somewhat true, it’s not entirely accurate to jump to the conclusion that the “real yield” is equal to “real growth” in the economy. Historically, the real yield has been rarely, if ever, equal to the real growth rate of the economy.
Why? It is partially because the government’s claim to real growth in the economy is not a constant. There is another myth that says that the government can never collect more than 20% of economic output in the form of taxes. Well, if you include state and local taxes in the calculation, the amount collected by the government has varied between 21% and 34% of GDP since 1954. The idea that there is some fixed upper or lower limit to the amount the government can collect in taxes is another myth.
For lenders (or creditors), what matters is the government’s ability to pay its bills as they come due. That ability may be related to GDP, but it is not determined mechanically by GDP. Nominal rates on government debt reflect supply and demand for government debt but do not predict economic growth for the nation as a whole.
Myth #4: TIPS predict inflation ratesIn 1997, the U.S. Treasury followed the lead of other governments and issued inflation-protected securities. These pay a fixed coupon rate, but the principal amount against which the coupon is paid does change depending on the realized rate of inflation. At maturity, the debt pays the face value or the inflation-adjusted value, whichever is higher. This gives investors a form of protection against inflation by adjusting the interest payments for changes in the inflation index used by the Treasury. Currently, the inflation adjustment occurs semi-annually and is based on the Consumer Price Index (CPI) for all urban consumers.
If you were to take the yield on 5-year TIPS and compare it with the yield on a 5-year Treasury, the difference is something called the “breakeven rate of inflation.” This is the rate of the CPI increase that would have to be realized in order to make investors indifferent between investing in 5-year TIPS or a 5-year Treasury. If realized inflation is higher than the breakeven rate, then the investor does better with the TIPS. If realized inflation is lower than the breakeven rate, then the regular security does better than the TIPS. The media—and some strategists—have referred to this difference as the “market’s expectation for inflation over the next five years.”
However, that just doesn’t work.
There are numerous reasons why an investor should not confuse the “breakeven rate” with a “market expectation of inflation,” but here are two primary reasons: TIPS don’t trade as much as regular Treasury securities, so there is a “liquidity premium” attached to regular Treasury securities. And, TIPS provide a form of inflation insurance that is incredibly valuable to investors, so you cannot equate the breakeven rate to the market’s expectation of inflation. This latter reason is why TIPS can sometimes command negative yields. Sometimes, investors are so fearful of inflation that they are willing to exchange a dollar today for less than a dollar of purchasing power in the future for the peace of mind of knowing that the purchasing power cannot be eroded any further. This is why, even though I think inflation is going to be low over the next year, it might be perfectly reasonable for an investor to accept a negative yield if that investor doesn’t share my belief.
SummaryThere are many myths in the fixed-income market and probably even more in the equity market. Remember that there is no one single interest rate for a market. There are many rates, and they all have their own determinants and dynamics. The second is that interest rates can, and do, go negative. If you’ve ever “paid a bank” to hold your money, you know firsthand that interest rates can go negative—and for good reason. The third is that interest rates on Treasury securities do not predict growth rates of the economy. They may be related, but an increase in rates does not mean growth is going to be higher in the future. Finally, TIPS do not predict inflation. TIPS provide inflation insurance and—as most people who buy or sell insurance know—insurance comes at a price. Hopefully, by knowing the myths and facts, you can make better decisions about fixed-income investing.