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Why Buying Money-Losing Investments Can Be a Good Strategy

MarketWatch columnist Brett Arends recently noted that TIPS with maturities of five years or less have negative yields, saying: "No ifs, ands or buts: This sucker will make you poorer!" Why are people buying short-term TIPS bonds that will actually lose them money? Arends suspects that "you can blame the usual Wall Street culprits, like investor ignorance, unscrupulous brokers and, of course, the 'dumb money' fund industry." He concludes: "It's crazy. Totally nuts."

The problem isn't with investors, but with Arends having the wrong perspective. Jared Kizer, co-author of The Only Guide to Alternative Investments You'll Ever Need with me, gives the proper perspective on the issue.

While it's true that short-term TIPS yields are generally negative (which means that real returns are negative on these securities), the negative yields reflect the flight to safety by investors. Investors are currently willing to accept a relatively small real loss to both protect the principal on their investments and avoid the risk of unexpected inflation. Remember that unless inflation is less than the negative real yield on TIPS, investors won't have a nominal loss -- though they'll earn a negative real return regardless of what inflation does. With that said, the question Arends should have asked is: "What is the yield on alternative investments -- nominal fixed income investments of similar credit quality?"

At the close on Friday, five-year TIPS had a yield of -0.46 percent. The current consensus five-year inflation forecast of professional economists is 2.1 percent. Thus the expected nominal return is 1.64 percent. With five-year nominal Treasury bonds yielding 1.86 percent, the expected real return on these bonds is -0.24. So while these bonds aren't guaranteed to provide a negative real return, the expectation is that they will. And what's worse, if inflation is just 0.22 percent higher than expected, they'll provide a lower real return than the five-year TIPS. Thus, investors in TIPS are only paying an insurance premium of 0.22 percent to protect against the risk of unexpected inflation. That seems a relatively cheap price to pay in light of all the concerns investors have about this risk (concerns that have fueled the rise in the price of gold).

Here's another example. Five-year high-quality municipal bonds currently have a yield of about 1.45 percent, well below the expected inflation rate. So it isn't TIPS alone that have expected real returns less than the inflation rate. Arends is suggesting that all investors in short- to intermediate-term bonds are nuts. The alternative answer seems far more likely.

One last, but very important point: Whenever yields on safe fixed income investments are at historically low levels, investors tend to lose discipline and start "stretching for yield." This is especially true of investors who take an income approach to their portfolios -- limiting spending to only interest and dividends. To generate more current income, investors will stretch for yield either by:

  • Investing in bonds whose credit risk is greater than they would otherwise accept
  • Extending maturities of nominal bonds, taking more inflation risk than they would otherwise accept
The way to avoid these errors is to first have an investment policy statement that clearly defines the credit quality and maturity risks you're willing to accept. The second is to take a total return approach to your portfolio, instead of an income approach.

The bottom line is that the higher yields on nominal bonds as compared to TIPS are just what might be called a "money illusion." This is a mistake you shouldn't make.

More on MoneyWatch:
Chasing Yield Is Never a Good Strategy 5 Reasons You Should Avoid Hedge Funds What the End of the American Age Means for Your Portfolio Why Successful Economies Don't Mean Great Stock Returns Interest Rates: Why Waiting for Rates to Rise May Cost You
Three ways I can help you become a wiser investor:

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