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Understanding the Wealth Flow of Bonds

This piece assumes that you have read my two prior blogs pertaining to economics…

Ever wonder how astronomers map the stars? First imagine a sphere that shares the center of the Earth but is larger than the Earth. The stars are mapped onto this larger sphere, using a special coordinate system. Next imagine a line extending from the Earth's north and south poles, with the earth spinning like a top around this line. Extending this line in both directions to the larger, outer sphere identifies two points of reference for the celestial coordinate system.

All good, but what does this have to do with economics?

Because like a spinning top, the Earth experiences precession, a slow wobbling of the north-south axis relative to the stars.

Which means that every year the coordinate system used to map the stars changes, that the two points of references move relative to the stars.

What did the astronomers do? No, being the scientists that they are, the astronomers all agreed that the location of the north-south pole relative to the stars in year 2000 would be the standard location of measurement for years moving forward.

Because being logical is what scientists do.

Great, but what does this have to do with economics?

Here is an idea. How about make economics a little more scientific, and a little less dismal, and all agree that the value of a dollar, the standard unit of financial measurement, should refer to a “standard year”.

I randomly choose year 2020, but in hindsight perhaps I should have chosen year 2000, in alignment with the apparently more logical astronomers.

Let’s apply this new way of thinking to analyzing the wealth flow of bond investments.

In year 2020, you purchase a ten-year $100,000 bond with an annual yield of 2%, or $2,000. Ten years later, when the bond matures, you receive back your original investment of $100,000, because that is what happens when you hold a bond to maturity, you get your money back, the debt is repaid.

Or was it? Was the wealth flow positive?

For now, assume that the annual inflation rate is unrealistically fixed at 3%.

Need to explain the upcoming overly complicated chart.

In year 2020 the $100,000 principle is invested. Or to be more scientific, $(2020)100,000 was invested.

In year 2021, with a compounded inflation of 3%, the $2,000 payment in 2021 stores the same amount of wealth as $(2020)1,942. Likewise, if the principle were to be paid back that year, in 2021 dollars, the wealth returned would be $(2020)97,087. Adding the total payments received with the returned principle, all converted to 2020 dollars, allows us to compute the all-important “wealth ROI”.

As this is a 10-year bond, this process is repeated through year 2030, and as one can see, thanks to an inflation rate that is higher than the bond yield, the longer one holds this bond, the more wealth you lose.

All while earning dollars.

Since we are interested in earning wealth, let’s instead assume that you wisely purchased a ten-year bond with a 4% yield.

On the surface good news! It appears that your wealth flow is positive! But not so fast, unless this is a tax-free municipal bond, you will need to pay taxes on your income. Will assume a 35% tax rate.

Ouch. The tax payment has the same effect as a lower yield, and once again you are losing wealth. At the same time that the government is collecting wealth from you.

One more chart. Let’s makes things a little more interesting and add in a variable inflation rate, in this case, an increasing inflation rate. What effect does this have on your bond wealth flow?

Note that in the early years, with a low inflation rate of 2%, if you were able to cash out, or sell the bond, the wealth flow was positive. But as the rate of inflation increases, the wealth flow direction shifts, and the higher the rate of inflation, the more wealth you will lose.

This is the inherent danger of investing in long term bonds with a fixed yield. If the rate of inflation were to increase, you should expect to lose wealth on your bond holdings.

And while the opposite is true, that a lower rate of inflation would improve your wealth ROI, chances are that your bond will be called (i.e. your principle returned prior to maturity), before you realize too much wealth gain. But that is a topic for a later blog.

Given that the rate of inflation, and associated interest rates, are at historical lows, is it more likely that the rate of inflation will increase or decrease in the future?

And yes, I understand that this “new math” is only as good as our CPI data. But let’s agree that at a minimum, it is a step in the right direction.

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