Last Updated Nov 4, 2010 10:03 AM EDT
Investors seem to have a problem that I call the money illusion: the inability to clearly understand the difference between real and nominal rates. While they wonder why anyone would buy a bond with a yield of -0.55 percent, they don't realize they're already buying bonds with negative expected returns.
The yield on nominal five-year Treasury bonds has been consistently below 2 percent since late June 2010. At the same time, the Philadelphia Federal Reserve's Survey of Professional Economists projects an inflation rate of 2 percent over the next five years, down from 2.2 percent in the prior quarter. Thus, investors have been buying nominal bonds with negative expected real returns for quite a while. And buyers of nominal bonds are taking risks that investors in TIPS don't -- the risk of unexpected inflation. In other words, the yield of nominal bonds actually has three parts:
- A real rate
- The expected rate of inflation
- A risk premium for unexpected inflation
- If inflation is less than 1.7 percent, the nominal bond will earn a higher return.
- If inflation is higher than 1.7 percent, the TIPS will earn the higher return.
There's one last important point. Another equally safe option involves -- FDIC-insured CDs. Today, five-year CDs can be bought with yields as high as 2.6 percent (with a three-month early withdrawal penalty). That changes the break-even inflation rate relative to TIPS to 3 percent (less than forecasted inflation). Thus, you might want to consider CDs as alternatives where available. While you would be taking some risk of unexpected inflation, the three-month early withdrawal penalty offers protection at a very low price.
More on MoneyWatch:
TIPS Update for October
Inflation or Deflation: Which Economic Risk Is Greater?
How to Hedge Both Inflation and Deflation
Can Investing Be Too Simple?
The Economy Isn't the Same as the Market
Hear Larry Swedroe discuss current investment trends and topics every Sunday at noon on 550 AM KTRS in St. Louis or streaming via the KTRS Web site. Can't catch the show? Download the podcast via www.investmentadvisornow.com or through the Buckingham Asset Management podcast page on iTunes.