Paul Solman answers questions from the NewsHour audience on business and economic news on his Making Sen$e page. Here is Thursday’s query:
Barbara Pendergrast — Germantown, Tenn.: Mr. Solman, Do you think short-term bonds are too much of a risk when interest rates are this low?
Paul Solman: No, Ms. Pendergrast, short-terms bonds are in fact no risk when rates are this low and that’s precisely because they’re short-term. If you are only lending money for a week or month, say, and interest rates rise, you will get back your principle soon enough and reinvest it at the new higher rate. It is long-term bonds that are vulnerable to interest rate rises, since your money is tied up for a substantial period of time.
But thanks for the question, because it affords me to revisit an investment idea this page has raised over the years. Ever since I began answering questions in 2007, readers have sought investment counsel. I make no claim to unusual perspicacity but I have, as viewers may have noticed, been around, and tend to know of options that others may not. So I’ve tried to provide what answers I can.
I also have a host of sources and friends in the world of business and economics. Among them are true investment experts like Boston University’s Zvi Bodie, who has appeared on this page pretty regularly from its earliest incarnation. Zvi has long been a champion of “TIPS” — Treasury Inflation-Protected Securites – and of I-Bonds. Indeed, he persuaded me to invest in a TIPS mutual fund back in 1997 when one was first created by my retirement trustee of that era, TIAA-CREF.
When I began answering questions here, I figured the most honest answer I could give to investment queries was to share my own choices. At the least, I was putting my money where my mouth is. And so, with the eternal caveat that past performance is a godawful guide to future results, I have explained the advantages of TIPS and I-bonds as I understood them, assisted from time to time by Zvi. The main plus: they protect against inflation by promising a cost-of-living adjustment, tied to the Consumer Price Index. Historically, TIPS and I-bonds have paid an additional interest rate that varies depending on what investors bid — what they bid, that is, in order to buy the bonds. In 1997, this “base rate” (before inflation adjustment) was 3.7 percent for bonds that would mature in 30 years.
As I neared so-called retirement age, my investment mantra been: preserve capital, not make a killing. The way I figured it, getting a “real” (ie, inflation-adjusted) return of nearly 4 percent was one sweet deal for the aging and risk averse.
I had an additional reason for liking TIPS. If I had become so enamored of decent-yield safety, why wouldn’t the same be true for a vast number of investors in the sonic Baby Boom coming in my wake as they neared their supposedly golden years, fearing they could turn to lead.
Admittedly, TIPS interest is only paid when the bond matures while in the interim, one is obliged to pay taxes on the interest. But if TIPS are held in a tax-deferred retirement account like an IRA, so what? No taxes until withdrawal. TIAA-CREF, the pension manager for my employer, Boston’s WGBH Educational Foundation, offered a TIPS mutual fund, which made the investment trivially easy. I seized the day.
And yet, when I talked to friends and family alike, none were invested in TIPS. Indeed, not a one had ever heard of them. Why? I asked Zvi, their stalwart champion. Because brokers never push them, he explained, and private pension plans rarely offered them. There was no money in it. In 2004, when I left WGBH and went to work directly for the NewsHour, I called my new plan advisor. Nope, no TIPS offered by the new pension management firm. Why not?
“If I had to guess, there is no spread where the vendor can make money on those assets,” said the NewsHour’s own plan consultant. (I took notes.) “They’re not going to put anything into their program that does not have some possibility of profit. They have to cover their costs. If not, the prices of their other products would have to go up.”
That was 2004. Seven years after the advent of TIPS, that is, the investment remained something of a secret. But look, I thought, Baby Boom investors will find out eventually. And as they do, little by little, they’ll buy more and more TIPS. As a result, the government will be able to offer a lower and lower interest rate – in addition to the inflation adjustment – to find new buyers. That should mean, I divined, that those of us who bought in early – at the higher interest rate – would do very well indeed as our old, high interest bonds increased in value, relative to newer ones paying less interest. (This is why bond prices go up when yields go down, and vice versa. Mainly long-term bond prices, as I explained at the outset, above.)
Whether by luck or foresight, my bet, it turns out, has paid off. Had readers followed my own investment trajectory, they would have more than held their own against the markets with TIPS, which have performed admirably – an annualized return of better than 7 percent since I first alerted readers to them online for the NewsHour in early 2008; slightly better even than a non-inflation-protected US government bond fund; considerably better than stocks, real estate or even an index of commodities (though not gold, which has compounded at 12 percent a year). I have explained that TIPS have remained my asset of choice ever since, e.g., here.
But the past is never more than prelude and in recent months, as faithful readers will know, I have become more and more nervous about TIPS as they have risen in value. Today, they are at an even more vertiginous high in price; low, in yield.
“Markets are driven by fear and greed.” My particular psyche proves that saying at least a half-truth. As an investor, I am a devout coward. But I’m a nervous coward. And so, when an investment or asset class reaches unprecendently lofty heights, I quiver. Have I been smart or lucky to date? No one will ever know. And even if “smart,” how often has yesterday’s genius proved tomorrow’s dunderpate?
In moments of temporary hubris, I think of Sir Isaac Newton, mathematician, alchemist and investor. Newton was England’s Master of the Mint in the early 1700s and, history records, a good one. Yet for all his monetary sophistication, here is a picture of his participation in the most famous investment bust of the 18th century, the South Sea Bubble..
By contrast, as we’ve reported on the NewsHour, George Friedric “Messiah” Handel invested wisely in South Sea stock, though luck seems to have been, as usual, a major factor.
But back down from the sublime to the more nearly ridiculous: my investment portfolio. It is about to undergo a major shift. That is, I am on the verge of selling much of my TIPS bond fund — Vanguard’s very low cost VAIPX — in an attempt to protect my retirement with some less volatile investment. Having shared my portfolio in the past, I feel obliged to report any changes to it. Plus, I’m trying to protect myself. A fusillade of email blame should TIPS tank would be demoralizing; had I myself “gotten out” of the investment and failed to say so, wrath would be warranted.
Right now , lending money to the Treasury for 30 years by purchasing a TIPS that matures in December of 2042 carries a “base rate” of .35 percent. Compared to 3.7 percent 15 years ago. Yes, you would still get the inflation rate, which is running at roughly 1.8 percent a year these days. Yes, that inflation rate could conceivably soar, as it did in the ’70s, and you would be protected. But all else equal, buying a 30-year TIPS today is lending Tim Geithner or his successor money at a net interest rate of about 2.15 percent, a rate that seems more likely to go up than down, in which case the value of the bond is more likely to go down than up.
So where will the money go? Here, I confess to being, as my father once said about my job at the NewsHour, “absurdly fortunate.” I happen to retain a guaranteed annuity retirement account at TIAA-CREF via my former employer, WGBH. It pays a floor of 3 percent a year and is fully liquid. Once upon a time, the annuity didn’t seem especially attractive, as I never imagined long-term rates would sink so low. Remember: I was worried about inflation.
Unfortunately for most readers, only previous account holders can access this 3 percent floor rate, which was discontinued as of 2010. But, with five grandchildren, I am appropriately grandfathered in. And even those of you without grandkids will be grandfathered – or grandmothered — so long as you have an existing TIAA-CREF “Group Supplemental Retirement Annuity.”
Presumably, few of you will be so lucky. If not, then, what should you do? What would I have done if I hadn’t lucked out with my old TIAA-CREF account?
Well, I was about to transfer a modest chunk — maybe a fifth — of my TIPS money into some form of “cash.” Those who have bothered to look at my portfolio pie chart will have seen that the ratio of TIPS to “everything else” is the same as Republicans over Democrats in South Carolina: about 55-45. Until I heard of the 3 percent TIAA-CREF option, I was aiming for something like 45-55, with more of the money in “cash.”
And this brings us back to your question, Ms. Pendergrast. Because “cash,” practically speaking, is just a form of short-term bond. I was looking at a short-term corporate bond mutual fund when I learned of my better option. I was thinking of putting more money in stocks and still am. In any case, I would still have chosen a fund managed by Vanguard, since it boasts the lowest management rates of any money management firm I know. But bottom line, most of my money would have remained in my Vanguard TIPS fund, because of my inveterate cravenness.
Last words. I’m practicing full disclosure here, not peddling investment advice. All I firmly believe in is diversification — across firms, asset classes, even currencies. I don’t think anyone has a sure way of making genius returns, unless they’re cheating. I admit that I don’t know that for sure. What I do know for sure is that if there were genius investors, I wouldn’t be able to distinguish them from the lucky ones before the fact. And if, after the fact, you somehow convinced me they had been geniuses, I would remember that past performance has so often proved a godawful guide to future results.
But I do know one thing. If you’re worried that interest rates are going up, short-term bonds are not a risky approach.
ps: Zvi Bodie has just read this and weighs in:
Zvi Bodie: IMHO you did the right thing for the right reasons. But perhaps you should remind folks that I Bonds do not pose the same risk as TIPS, despite the fact that they have a 30-year maturity. The reason is that the US Treasury will cash in I Bonds at their full value plus accrued interest at any time after 1 year. With 30-year TIPS, however, the Treasury does not pay back the principal until their final maturity date.
pps: Money manager/economics songster Jon “Merle Hazard” Shayne, featured on the Business Desk yesterday, also weighs in, this time with a correction, proving that I get by with more than a little help from my friends:
Jon Shayne: In your post today, you made it clear that by short-term bond, YOU meant things that mature in a few weeks.
However, in the mutual fund industry, “short-term” generally means 2 or 3 years. So these would in fact get hurt a bit if interest rates rose.
The mutual fund industry uses other terms to describe what you were thinking about. “Money market funds” hold paper that mature in 90 days or less (I have looked at many and that’s where they always seem to be). “Short-duration” bond funds hold paper that matures in about a year. So “short-term” funds, at 2 or 3 years, are actually the third way-stop out on the maturity curve, not the first. In industry parlance…which is probably what the questioner had in mind, after talking to her broker or what have you. (She is a fellow Tennessean so, I have to look out for her.)
Here is an example from a very plain-vanilla product, the Vanguard Short-Term Bond ETF: https://personal.vanguard.com/us/funds/snapshot?FundId=0924&FundIntExt=INT
Note the average maturity of what they hold is 2.8 years. (And duration is 2.7 years…there is a somewhat subtle difference between those two measures, but you can use maturity.)
Always looking out for you…
This entry is cross-posted on the Rundown — the NewsHour’s blog of news and insight. Follow @paulsolman