Best Investments for Stagflation
My macroeconomic forecast for the next 3 to 5 years which I unveiled in my blog of April 12, 2010 predicts stagflation. This week's blog outlines which investments are the best for stagflation, focusing on commodities, precious metals and gold. Other suitable investments will be discussed next week.
As always, be sure you understand the tax consequences of your investments, how the investment works and what your exit strategy will be.
Best investments for stagflation: Commodities, precious metals or gold (see blogs Gold - January 2, 2010 and Natural Gas - February 8, 2010).
The following are methods for investing in commodities, precious metals or gold:
1. Commodity producing companies. Examples of commodity producing companies are coal and Natural Gas (NG) producer Consol Energy Inc. (CNX) and gold, silver and copper producer Goldcorp Inc. (GG). Consol Energy is the largest coal exporter to China for steel production. Canada Goldcorp is one of the largest gold producers in the world. I own the following commodity producing companies:
+ Lundin Mining Compnay - LUNMF.PK
+ Advantage Oil and Gas Ltd. - AAV
+ Pegrowth Engery - PGH
+ Penn West Engery - PWE
2. Future Based Commodity ETFs. Before you buy future based commodity ETFs you may want to read the following article “Commodities are a Rock in a Hard Place”:
http://www.morningstaradvisor.com/articles/article.asp?docId=17924. Before buying a future based commodity or commodity index you need to understand the contango and backwardation effects (you should also understand the tax consequences of a taxable account). Two famous future based commodity ETFs are States Oil (USO) and United States Natural Gas (UNG). These funds have been influenced by the contango effect in the future energy market. UNG lost over 50% of its stock value in the last year. A worthwhile article on the contango effect on UNG is “What’s Wrong With UNG?” http://etfdb.com/2009/whats-wrong-with-ung.
3 . Exchange Traded Funds (ETFs) or Mutual Funds (MF) index of commodity producing companies. For a very good article on ETFs of commodity producing companies indexes see http://seekingalpha.com/article/195688-the-benefits-of-equity-commodity-etfs. You can buy selector based ETFs, for example metals and mining (XME), global coal (PKOL), steel (SLX), etc.
4 . ETFs index of commodities. Before you buy a commodities index ETF in your taxable account you should read the following article about tax consequences of ETFs: http://www.investopedia.com/articles/exchangetradedfunds/08/etf-taxes-introduction.asp.
+ Powershare DB Commodity Index Tracking Fund - DBC
+ Dow Jones AIG Commondity Index Fund - DJP
These ETFs have about 20 commodities in the index. They include, for example, oil, NG, heating oil, gold, corn, wheat, etc. These ETFs have large total assets of over 2 billion dollars and at the same time large bid / ask spreads (also very high fees for ETFs). These funds all use future contracts and made also be affected by the contango effect.
5 . ETFs or MFs index of commodity producing countries. These also have currencies implications. I own the following ETFs and MFs indices of commodity producing countries (each of these funds has about 50% commodity stocks within its index):
+ S & P BRIC 40 SPDRS - BIK
+ Claymore/BNY BRIC - EEB
+ DWS Latin America - SLA
6. Real commodity assets (owning a forest or mine). If you have a lot of money like the Yale Endowment Fund (http://www.yale.edu/investments/Yale_Endowment_09.pdf) you may want to buy real assets such as a forest, large commercial building, or oil or natural gas fields. The Yale portfolio manager, David Swensen, one of the top investors in the world for the last 25 years, has been increasing his holdings in real assets over the last 3 years. It is an investment category through which you can take advantage of pricing efficiencies. One of the best ways forthe average investor to buy real assets is by buying Real Estate Investment Trust (REIT) companies. For example, Timberland has been one of the best investments for the last 20 years. Its return during the past two decades has been 12.8%. There are a number of Timberland REIT companies that own extensive timberland acres. For example, Plum Creek (PCL) owns over 7 million acres and has a yield of 4.3%.
In next week’s blog I will put forward best investments for EU countries. Please chime in with comments about my future economic forecast and best investment opportunities for that economic environment.
© 2010 Paul Cusick
Paul
Monday, May 24, 2010
Tuesday, April 27, 2010
Worst Investments for Stagflation
My macroeconomic forecast for the next 3 to 5 years which I unveiled in my last blog is for stagflation. This week's blog will be about which investments are the worst for stagflation. As for myself, I don’t tie my whole portfolio to my macroeconomic forecast. I could be wrong, so I tilt some of my portfolio to stagflation investments (10 to 20%) and the rest elsewhere. It helps to hedge so that, if my forecast is wrong, I am not forced to sell assets that have lost value. Today a lot of people are finding themselves in the unfortunate position of needing to sell their houses to raise cash to pay debt and living expenses. You never want to be forced to sell an asset that has lost value. A well-diversified portfolio is key - you never put all your eggs in one basket.
I will review all of my investments against my economic forecast to determine whether any are no-nos for the forecasted economic environment. For example, for stagflation medium and long duration bonds funds are not good investments. If I have investments that are medium or long term bond funds I will decrease or eliminate my investment in that fund.
Also, always understand the tax consequences of your investments, how the investment works and what your exit strategy will be.
Worst investments for stagflation:
Long or medium duration bonds (see blog Bonds - February 27, 2010). For example, if you are invested in Vanguard Long-Term Investment Grade Bond fund (VWESX) with the average duration of 12.1 years and interest rate increases by 2%, your investment will decrease by 24.2%. If you invested $100,000 in the fund, after the 2% increase in interest rate, your investment value would $75,800. The time to invest in long term duration bond funds is when inflation and interest rates are at their highest and will be decreasing in the future. That’s why long term bonds have been very good investments over the last 3 years with declining interest rates. Over the last 3 years Barclays Capital US Aggregate Bond Index has returned 6.14% and the S&P 500 Index has returned -4.17%. This is why you do not want to follow performance. With the economic environment changing to higher interest rates and inflation you would not want to be invested in long or medium duration bond funds.
Long term fixed rate annuities, Guaranteed Investment Contracts (GIC) or anything that pays a fixed income. GICs are like Certificates of Deposit (CDs) but they are not guaranteed by the Feds and FDIC; they are only guaranteed by the company that issues them to pay the fixed interest rate. Today you can buy a GIC that will pay you 3.0% annually for 5 years. That 3% income is locked in for 5 years. If the inflation rate is 7% you lose 4% on you investment every year. GICs work like every other type of fixed income investment that will not protect you against rising inflation. The time to buy long term fixed income investments is when inflation rates are declining.
Investments in cash, for example, CDs, savings accounts, etc. Cash, or cash equivalents, generally provide the worst protection against inflation since it will not keep up with inflation. If inflation is 9% and you are getting paid a 2% interest rate annually for your saving account in 10 years (rule of 72) you would lose almost 50% of the value of your investment to inflation. During periods of inflation you just want only enough cash for emergencies. This might be 6 months of your living expenses. You may want to do CD laddering to get the best return for your emergency cash fund.
Stocks. In the short to medium term stocks have an inverse relationship to the Consumer Price Index (CPI). You will need to be very selective on the stocks that you invest in. Pricing power is very important when you have stagflation. Companies that cannot raise prices faster than their input costs will not do well in this environment. If you are a paint manufacturer and cannot raise your prices for paint faster than your major input oil you are going to experience a decrease in profitability or lose money. This will drive down the stock price. Companies that produce durable goods do not do well in a stagflation environment. (Durable goods are products that are not purchased frequently, for example appliances, home and office furnishings, and jewelry.) Examples of companies which are unlikely to prosper in a stagflation environment:
Whirlpool (WHR)
Boeing (BA)
Tiffany (TIF)
In next week’s blog I will be talking about the best investments for stagflation. Please chime in with comments about my future economic forecast and best investment opportunities for that economic environment.
© 2010 Paul Cusick
Paul
I will review all of my investments against my economic forecast to determine whether any are no-nos for the forecasted economic environment. For example, for stagflation medium and long duration bonds funds are not good investments. If I have investments that are medium or long term bond funds I will decrease or eliminate my investment in that fund.
Also, always understand the tax consequences of your investments, how the investment works and what your exit strategy will be.
Worst investments for stagflation:
Long or medium duration bonds (see blog Bonds - February 27, 2010). For example, if you are invested in Vanguard Long-Term Investment Grade Bond fund (VWESX) with the average duration of 12.1 years and interest rate increases by 2%, your investment will decrease by 24.2%. If you invested $100,000 in the fund, after the 2% increase in interest rate, your investment value would $75,800. The time to invest in long term duration bond funds is when inflation and interest rates are at their highest and will be decreasing in the future. That’s why long term bonds have been very good investments over the last 3 years with declining interest rates. Over the last 3 years Barclays Capital US Aggregate Bond Index has returned 6.14% and the S&P 500 Index has returned -4.17%. This is why you do not want to follow performance. With the economic environment changing to higher interest rates and inflation you would not want to be invested in long or medium duration bond funds.
Long term fixed rate annuities, Guaranteed Investment Contracts (GIC) or anything that pays a fixed income. GICs are like Certificates of Deposit (CDs) but they are not guaranteed by the Feds and FDIC; they are only guaranteed by the company that issues them to pay the fixed interest rate. Today you can buy a GIC that will pay you 3.0% annually for 5 years. That 3% income is locked in for 5 years. If the inflation rate is 7% you lose 4% on you investment every year. GICs work like every other type of fixed income investment that will not protect you against rising inflation. The time to buy long term fixed income investments is when inflation rates are declining.
Investments in cash, for example, CDs, savings accounts, etc. Cash, or cash equivalents, generally provide the worst protection against inflation since it will not keep up with inflation. If inflation is 9% and you are getting paid a 2% interest rate annually for your saving account in 10 years (rule of 72) you would lose almost 50% of the value of your investment to inflation. During periods of inflation you just want only enough cash for emergencies. This might be 6 months of your living expenses. You may want to do CD laddering to get the best return for your emergency cash fund.
Stocks. In the short to medium term stocks have an inverse relationship to the Consumer Price Index (CPI). You will need to be very selective on the stocks that you invest in. Pricing power is very important when you have stagflation. Companies that cannot raise prices faster than their input costs will not do well in this environment. If you are a paint manufacturer and cannot raise your prices for paint faster than your major input oil you are going to experience a decrease in profitability or lose money. This will drive down the stock price. Companies that produce durable goods do not do well in a stagflation environment. (Durable goods are products that are not purchased frequently, for example appliances, home and office furnishings, and jewelry.) Examples of companies which are unlikely to prosper in a stagflation environment:
Whirlpool (WHR)
Boeing (BA)
Tiffany (TIF)
In next week’s blog I will be talking about the best investments for stagflation. Please chime in with comments about my future economic forecast and best investment opportunities for that economic environment.
© 2010 Paul Cusick
Paul
Monday, April 12, 2010
Stagflation and Analysis
This week’s blog is my forecast for the economy for the next 3 to 5 years and my supporting analysis. My forecast is for stagflation which is high unemployment rate with inflation. Remember the Carter administration (1976 to 1980) which is known for stagflation and the misery index (employment rate + inflation rate)? We could be headed for the same economic environment that existed in the Carter years.
Interesting URLs:
Misery index: http://www.miseryindex.us
Money supply definition (M1, M2 and M3): http://en.wikipedia.org/wiki/Money_supply
US Debt Clock: http://www.usdebtclock.org
Analysis of the major causes of inflation:
1. One of the major causes of inflation occurs when the money supply grows faster than the potential output of the economy or real GDP. Over the last two years the M1 money supply has increased by 25.5% and M2 has increased by 11.5%. For the same time period the real GDP has decreased by .5%. This will promote higher inflation rates over the next 3 to 5 years. At the same time, the Feds may decide to keep interest rates low for political reasons. Examples of political reasons why the Feds would keep interest rates low are: to keep mortgage rates down (to help get us out of the housing crisis), to promote higher employment, keep the federal government debt payment level lower, etc. This will bring about more inflation as it leads to unsustainable levels of growth and inflation because cheap money is available. With lower interest rates on treasury bonds the Feds will be the lender of last resort and will need to buy the bonds. The only way they can buy more bonds is by printing more money (just like the last two years) and increasing inflation. The Feds or Congress may also determine the only way to pay off the national debt (over $12.7 Trillion and counting) is to make money cheaper through inflation. This will be the main cause of inflation over the next 3 to 5 years.
2. Rise in production cost of goods, for example, increases in raw materials and / or labor cost. There will be very little or no increase in labor cost over the next 3 to 5 years. Instead there will be downward pressure on labor cost during this period with jobs moving overseas and high unemployment. Cost of goods increases will stem from increases in the cost of raw materials, for example, corn, wheat, oil, natural gas, etc. There will continue to be increased demand for commodities in the emerging countries (for example, China and India) which will increase the cost of raw materials. Since commodities are one of the best investments when there is inflation, hedge fund managers and other investors will increase their investments in commodities, which will further drive up the price of raw materials.
3. Change in availability of supplies. The Arab Oil embargo of the mid 1970’s is a classic example of change in availability of supplies. The embargo caused an increase in the price of gas, paint, and other oil-based products. Inflation can also arise from speculation and increased demand from emerging countries. Of all the causes of inflation, this will be the wild card over the next 3 to 5 years. Oil is currently going up because of speculation. A major political event in the Middle East, Russia, etc. could drive up the price of oil to $150 a barrel or higher. For example, Iran is bombed by the US or another country seeking to destroy their nuclear power plants.
4. The consumer demands more goods and services than are available. This can lead to the seller increasing the price of the good or service and driving up the rate of inflation. I don’t see this being a factor driving inflation over the next 3 to 5 years.
5. Inflation can be artificially created through a circular demand by workers to increase wages (for example, because a change in supply increases cost of goods) which causes an increase in production costs which increases prices and leads to further demands for higher wages. This will not occur in the current economic environment. With the high unemployment rate and with the ability of companies to move jobs overseas, workers simply do not have the power to demand wage increases.
Employment analysis:
The total number of unemployed US workers is 15 million (this is the U3 number – see definition below) out of the total work force of 154 million (unemployment rate is 9.7%). If you want to decrease the unemployment rate to 5%, there would need to be more than 7.3 million new jobs created. If the US increases new jobs by 300,000 per month (factoring in 100,000 new employees entering the work force every month) it would take 36 months to get back to 5%. U6 unemployment rate is around 20%. That is another 15 million workers over and above the U3 number. If only 50% of these workers enter the work force, that is still 7.5 million workers. Including the U6 workers it will take 72 months (6 years) to get back to a 5% unemployment rate. If the job growth is 200,000, it will take 144 months (12 years) to achieve 5% unemployment. At no period in US history have we been able to generate job growth at 300,000 for a sustained period of time. It is going to be very difficult to grow jobs at this rate with so many jobs going overseas because of lower labor cost. The unemployment rate will decrease slowly over the next 3 to 5 years.
• U1: Percentage of labor force unemployed 15 weeks or longer.
• U2: Percentage of labor force who lost jobs or completed temporary work assignments.
• U3: Official unemployment rate per ILO definition.
• U4: U3 + "discouraged workers", or those who have stopped looking for work because current economic conditions make them believe that no work is available for them.
• U5: U4 + other "marginally attached workers", or "loosely attached workers", or those who "would like" and are able to work, but have not looked for work recently.
• U6: U5 + Part time workers who want to work full time, but cannot due to economic reasons
Summary:
Over the next 3 to 5 year period there will be an increase in the inflation rate driven by the money supply increasing faster than the real GDP, increases in commodities prices driven by increasing demand of emerging countries and speculation, and the US government wanting higher inflation to pay off the debt of the US government. The unemployment rate will slowly decrease over the next 3 to 5 years. For the next 3 to 5 years, we will be in a period of stagflation.
In next week’s blog I will be talking about best investments for stagflation. Please chime in with comments about my future economic forecast and best investment opportunities for that economic environment.
© 2010 Paul Cusick
Paul
Interesting URLs:
Misery index: http://www.miseryindex.us
Money supply definition (M1, M2 and M3): http://en.wikipedia.org/wiki/Money_supply
US Debt Clock: http://www.usdebtclock.org
Analysis of the major causes of inflation:
1. One of the major causes of inflation occurs when the money supply grows faster than the potential output of the economy or real GDP. Over the last two years the M1 money supply has increased by 25.5% and M2 has increased by 11.5%. For the same time period the real GDP has decreased by .5%. This will promote higher inflation rates over the next 3 to 5 years. At the same time, the Feds may decide to keep interest rates low for political reasons. Examples of political reasons why the Feds would keep interest rates low are: to keep mortgage rates down (to help get us out of the housing crisis), to promote higher employment, keep the federal government debt payment level lower, etc. This will bring about more inflation as it leads to unsustainable levels of growth and inflation because cheap money is available. With lower interest rates on treasury bonds the Feds will be the lender of last resort and will need to buy the bonds. The only way they can buy more bonds is by printing more money (just like the last two years) and increasing inflation. The Feds or Congress may also determine the only way to pay off the national debt (over $12.7 Trillion and counting) is to make money cheaper through inflation. This will be the main cause of inflation over the next 3 to 5 years.
2. Rise in production cost of goods, for example, increases in raw materials and / or labor cost. There will be very little or no increase in labor cost over the next 3 to 5 years. Instead there will be downward pressure on labor cost during this period with jobs moving overseas and high unemployment. Cost of goods increases will stem from increases in the cost of raw materials, for example, corn, wheat, oil, natural gas, etc. There will continue to be increased demand for commodities in the emerging countries (for example, China and India) which will increase the cost of raw materials. Since commodities are one of the best investments when there is inflation, hedge fund managers and other investors will increase their investments in commodities, which will further drive up the price of raw materials.
3. Change in availability of supplies. The Arab Oil embargo of the mid 1970’s is a classic example of change in availability of supplies. The embargo caused an increase in the price of gas, paint, and other oil-based products. Inflation can also arise from speculation and increased demand from emerging countries. Of all the causes of inflation, this will be the wild card over the next 3 to 5 years. Oil is currently going up because of speculation. A major political event in the Middle East, Russia, etc. could drive up the price of oil to $150 a barrel or higher. For example, Iran is bombed by the US or another country seeking to destroy their nuclear power plants.
4. The consumer demands more goods and services than are available. This can lead to the seller increasing the price of the good or service and driving up the rate of inflation. I don’t see this being a factor driving inflation over the next 3 to 5 years.
5. Inflation can be artificially created through a circular demand by workers to increase wages (for example, because a change in supply increases cost of goods) which causes an increase in production costs which increases prices and leads to further demands for higher wages. This will not occur in the current economic environment. With the high unemployment rate and with the ability of companies to move jobs overseas, workers simply do not have the power to demand wage increases.
Employment analysis:
The total number of unemployed US workers is 15 million (this is the U3 number – see definition below) out of the total work force of 154 million (unemployment rate is 9.7%). If you want to decrease the unemployment rate to 5%, there would need to be more than 7.3 million new jobs created. If the US increases new jobs by 300,000 per month (factoring in 100,000 new employees entering the work force every month) it would take 36 months to get back to 5%. U6 unemployment rate is around 20%. That is another 15 million workers over and above the U3 number. If only 50% of these workers enter the work force, that is still 7.5 million workers. Including the U6 workers it will take 72 months (6 years) to get back to a 5% unemployment rate. If the job growth is 200,000, it will take 144 months (12 years) to achieve 5% unemployment. At no period in US history have we been able to generate job growth at 300,000 for a sustained period of time. It is going to be very difficult to grow jobs at this rate with so many jobs going overseas because of lower labor cost. The unemployment rate will decrease slowly over the next 3 to 5 years.
• U1: Percentage of labor force unemployed 15 weeks or longer.
• U2: Percentage of labor force who lost jobs or completed temporary work assignments.
• U3: Official unemployment rate per ILO definition.
• U4: U3 + "discouraged workers", or those who have stopped looking for work because current economic conditions make them believe that no work is available for them.
• U5: U4 + other "marginally attached workers", or "loosely attached workers", or those who "would like" and are able to work, but have not looked for work recently.
• U6: U5 + Part time workers who want to work full time, but cannot due to economic reasons
Summary:
Over the next 3 to 5 year period there will be an increase in the inflation rate driven by the money supply increasing faster than the real GDP, increases in commodities prices driven by increasing demand of emerging countries and speculation, and the US government wanting higher inflation to pay off the debt of the US government. The unemployment rate will slowly decrease over the next 3 to 5 years. For the next 3 to 5 years, we will be in a period of stagflation.
In next week’s blog I will be talking about best investments for stagflation. Please chime in with comments about my future economic forecast and best investment opportunities for that economic environment.
© 2010 Paul Cusick
Paul
Saturday, April 3, 2010
Financial Reading Recommendations & Next Blog
This week I am doing research for the next blog in which I'll discuss the most likely future economic environment for the US: deflation, inflation or stagflation (high unemployment rate with inflation) and what the best investments for that economic environment might be. The US may be headed for sustained high unemployment and inflation. Readers who are old enough may remember the aptly named misery index from the 1970s which equaled the unemployment rate plus the inflation rate. If you are interested in the misery index and the historical and current data for the misery index you can check the following website: http://www.miseryindex.us
I read some very interesting documents and websites during the last week:
A.K. Barnett-Hart's Harvard undergraduate thesis about the market for subprime mortgage backed Collator Debt Obligations (CDOs) is a must read. This may be the best, most clearly written and most interesting document about subprime mortgage backed CDOs out there. If you want to understand CDOs and all the problems/issues that caused the financial meltdown this is required reading. Better yet, it should be required reading for every US congress person and financial regulator. President Obama should invite Ms. Barnett-Hart over to the White House for lunch to get a better understanding of the financial regulations needed by the US. URL for the thesis: http://www.hks.harvard.edu/m-rcbg/students/dunlop/2009-CDOmeltdown.pdf
The Yale 2009 Endowment Investments report (thanks Barry) is a very interesting document with a lot of good financial and investment information: http://www.yale.edu/investments/Yale_Endowment_09.pdf. David Swensen, Chief Investment Officer of Yale’s endowment for the last 25 years, is one the top money managers in the world. His return on investment has been 13.4% per year over the last 20 years. He has increased his allocation goal in real assets (real estate, oil and gas and timberland) to 37% for inflation protection and to capitalize on pricing inefficiencies in the asset class (from 29% in 2008). His allocations in domestic and foreign equities have decreased by 8% from last year. After reviewing the changes he is making in the endowment’s allocations it looks like he is protecting the endowment from inflation vulnerability in the future. Thus it would seem that Mr. Swensen is betting that an inflation environment looms in our economic future.
I reviewed the Feds website on the money supply of the US: http://www.federalreserve.gov/releases/h6/Current. This site lets you check out what is happening with the US money supply. There is a lot of interesting information on this site, for example: the increase of money in saving accounts and the overall increase in US money supply since 2008. It is interesting that the Feds ceased publishing the M3 numbers in March 2006 with the result that it is now harder to track the money supply growth. M3 includes the following: M2 + all other certificate of deposits (large time deposits, institutional money market mutual fund balances, deposits of euro dollars and repurchase agreements). The Feds did this, they say, to save money and because the data was not needed. I will start checking this website once a month for economic information.
The following 3 financial books are ones that I have read over the last 3 months and recommend. If you are interested, you can select the link and get a review of the books from the Amazon website:
The Ascent of Money: A Financial History of the World
The Greatest Trade Ever: The Behind-the-Scenes Story of How John Paulson Defied Wall Street and Made Financial History
The Big Short: Inside the Doomsday Machine
© 2010 Paul Cusick
Paul
I read some very interesting documents and websites during the last week:
A.K. Barnett-Hart's Harvard undergraduate thesis about the market for subprime mortgage backed Collator Debt Obligations (CDOs) is a must read. This may be the best, most clearly written and most interesting document about subprime mortgage backed CDOs out there. If you want to understand CDOs and all the problems/issues that caused the financial meltdown this is required reading. Better yet, it should be required reading for every US congress person and financial regulator. President Obama should invite Ms. Barnett-Hart over to the White House for lunch to get a better understanding of the financial regulations needed by the US. URL for the thesis: http://www.hks.harvard.edu/m-rcbg/students/dunlop/2009-CDOmeltdown.pdf
The Yale 2009 Endowment Investments report (thanks Barry) is a very interesting document with a lot of good financial and investment information: http://www.yale.edu/investments/Yale_Endowment_09.pdf. David Swensen, Chief Investment Officer of Yale’s endowment for the last 25 years, is one the top money managers in the world. His return on investment has been 13.4% per year over the last 20 years. He has increased his allocation goal in real assets (real estate, oil and gas and timberland) to 37% for inflation protection and to capitalize on pricing inefficiencies in the asset class (from 29% in 2008). His allocations in domestic and foreign equities have decreased by 8% from last year. After reviewing the changes he is making in the endowment’s allocations it looks like he is protecting the endowment from inflation vulnerability in the future. Thus it would seem that Mr. Swensen is betting that an inflation environment looms in our economic future.
I reviewed the Feds website on the money supply of the US: http://www.federalreserve.gov/releases/h6/Current. This site lets you check out what is happening with the US money supply. There is a lot of interesting information on this site, for example: the increase of money in saving accounts and the overall increase in US money supply since 2008. It is interesting that the Feds ceased publishing the M3 numbers in March 2006 with the result that it is now harder to track the money supply growth. M3 includes the following: M2 + all other certificate of deposits (large time deposits, institutional money market mutual fund balances, deposits of euro dollars and repurchase agreements). The Feds did this, they say, to save money and because the data was not needed. I will start checking this website once a month for economic information.
The following 3 financial books are ones that I have read over the last 3 months and recommend. If you are interested, you can select the link and get a review of the books from the Amazon website:
The Ascent of Money: A Financial History of the World
The Greatest Trade Ever: The Behind-the-Scenes Story of How John Paulson Defied Wall Street and Made Financial History
The Big Short: Inside the Doomsday Machine
© 2010 Paul Cusick
Paul
Monday, March 29, 2010
Deflation
This week’s entry is the second in a series of blogs on inflation and deflation, what are good / bad investments for those conditions and when inflation or deflation might occur. This week I focus on deflation.
Definitions of inflation, hyperinflation and deflation from the last blog (Inflation - March 21, 2010)
Definition of inflation from Yahoo Education: “A persistent increase in the level of consumer prices or a persistent decline in the purchasing power of money, caused by an increase in available currency and credit beyond the proportion of available goods and services.”
Definition of hyperinflation from Yahoo Education: “Extremely high monetary inflation.”
Definition of deflation from Yahoo Education: “A persistent decrease in the level of consumer prices or a persistent increase in the purchasing power of money because of a reduction in available currency and credit.”
Deflation can be caused by the following:
1. Increase in the supply of goods is growth deflation. This can lead to a decrease in the Consumer Price Index (CPI). A good example of this is Natural Gas (NG). Recent technological advancements have allowed the development of NG deposits previously thought to be unreachable and this has led to a decline in the price of NG. The Exchange Traded Fund (ETF) that tracks the future one month contracts of NG (UNG – United States NG Fund) is down from $60 in June 2008 to the current price of around $7. This can be good for the economy - when prices go down because of the increase of goods everyone’s wealth can increase. Since you are now paying less for NG, you can buy other goods or invest the money you saved.
2. Reduction in spending of consumers. When people refuse to spend money on goods it can lead to a decline in prices unless the money supply increases faster than the economy is growing. For example, when the unemployment rate increases consumers will start saving more money (the saving rate goes up) and the only way goods sell is if the price is decreased (i.e. the store has a 50% sale on goods to reduce their inventory). This can have a circular effect the result of which is to drive down prices. The consumer will not buy anything unless it is on sale (price reduction). For example, I will not buy a new automobile unless there is $3000 rebate and zero percent financing.
3. Reduction in investment value or liquidity in the market. For example, the stock market or real estate has a significant decrease in value, and consumers have less money to spend. For example, the home owner can no longer use his house as an ATM (take out money) because its value has decreased. He can’t go buy a new BMW by refinancing his house.
4. Bank credit deflation. Reduced availability of bank credit because of new rules regarding credit worthiness, the high bankruptcy rate, and central bank policies can make it more difficult for businesses and consumers to get loans. I cannot get a loan to buy a new automobile, house or start a small business. A corporation cannot get a loan to buy capital equipment. This can spur the decrease of the price of goods.
5. Reduction in government spending. For example, the federal government has to decrease spending on goods because its debt load (payments) makes up an increasing part of the budget. There is also a reduction in tax collection (the unemployed/underemployed pay less taxes, spend less on taxable goods, etc.) The resulting decrease in demand for goods feeds into a downward trend in prices. For example, states’ budgets have decreased because of lower tax collection, which can drive down the price of goods and services, and in turn drives unemployment higher.
The best investments for periods of deflation are the following:
1. Medium to long duration bonds. The Feds may reduce interest rates with the intention of stimulating the economy; this would drive up the value of a bond as interest rates decline. (Paradoxically, while this is usually one of the best investments for deflation, it would not work well now with interest rates at historic lows.)
2. Currencies, stock or assets of countries that do not have deflation. If you own assets or currencies in countries that do not have deflation, your assets will increase against the currency decreasing. For example, if you own the currency of Brazil which does not have deflation, you will have more money to purchase assets in the US.
3. Short Equities. During deflation companies have decreasing revenue and lower margins. This usually leads to decreasing stock prices for the majority of stocks. You could use ETFs to short or leverage short (i.e. 3X short) the market. For example, you could short the S&P 500 using ProShares Short S&P500 ETF (SP) or leverage short the S&P 500 using ProShares UltraShort S&P500 ETF (SDS).
4. Short leverage assets (for example real estate). As prices collapse the value of the asset will continue to decline. You will want to short any company or asset that is highly leveraged. The value of the asset will continue to unwind and companies or assets that are highly leveraged will continue to decrease in value.
5. Cash is king. You want to raise cash and have less debt. Assets will decrease over time and will become cheaper. If you have cash you will be able to buy a lot of assets at reduced prices.
6. High paying annuities. If you can lock in a high paying annuity it will continue to pay cash as interest rates decline and the value of the annuity will increase.
The worst investments for deflation are the following:
1. Highly leveraged assets. As the value of an asset is decreasing, it gets more costly to pay the debt. This is the worst investment that you can be in during deflation. For example, you own a house that is 100% financed, the value of the house is decreasing and it is more costly to pay the debt (woe to you if you will not be getting a raise or if your pay actually decreases!). You do not want to be forced to sell assets to generate cash during deflation.
2. Debt. Any debt will be more costly to pay off during deflation. Remember cash is king in deflation periods. If you have cash you can buy a lot of reduced cost assets.
3. Long Stock. You have to be very selective in the stocks you buy. There will be revenue, profit and margin pressure during deflation which will drive down stock prices. Companies that are highly leveraged (have a lot of debt) will not be good investments (it is more difficult to pay for debt when there is deflation).
Please add your insight. For example, when will the US have inflation or deflation? I would like to have an on-going discussion of financial and investing ideas.
Next week, I will write about when I think we will have inflation, deflation or stagflation. Future topics may include:
- What investments will be good investments with rising inflation and interest rates?
- Warning signs of inflation or deflation
- Shorting US currencies
- What sector will do the best in 2010?
- Update on performance of blog trades
- Financial rules / lessons (school of hard knocks)
- Other topics
In April I will be starting a financial website (www.paulsgang.com) and in the summer I will be kicking off a financial podcast with Fullstacks, Mr. C and C4.
© 2010 Paul Cusick
My favorite financial books that I have read in the last 3 months:
The Ascent of Money: A Financial History of the World
The Greatest Trade Ever: The Behind-the-Scenes Story of How John Paulson Defied Wall Street and Made Financial History
The Big Short: Inside the Doomsday Machine
Paul
Definitions of inflation, hyperinflation and deflation from the last blog (Inflation - March 21, 2010)
Definition of inflation from Yahoo Education: “A persistent increase in the level of consumer prices or a persistent decline in the purchasing power of money, caused by an increase in available currency and credit beyond the proportion of available goods and services.”
Definition of hyperinflation from Yahoo Education: “Extremely high monetary inflation.”
Definition of deflation from Yahoo Education: “A persistent decrease in the level of consumer prices or a persistent increase in the purchasing power of money because of a reduction in available currency and credit.”
Deflation can be caused by the following:
1. Increase in the supply of goods is growth deflation. This can lead to a decrease in the Consumer Price Index (CPI). A good example of this is Natural Gas (NG). Recent technological advancements have allowed the development of NG deposits previously thought to be unreachable and this has led to a decline in the price of NG. The Exchange Traded Fund (ETF) that tracks the future one month contracts of NG (UNG – United States NG Fund) is down from $60 in June 2008 to the current price of around $7. This can be good for the economy - when prices go down because of the increase of goods everyone’s wealth can increase. Since you are now paying less for NG, you can buy other goods or invest the money you saved.
2. Reduction in spending of consumers. When people refuse to spend money on goods it can lead to a decline in prices unless the money supply increases faster than the economy is growing. For example, when the unemployment rate increases consumers will start saving more money (the saving rate goes up) and the only way goods sell is if the price is decreased (i.e. the store has a 50% sale on goods to reduce their inventory). This can have a circular effect the result of which is to drive down prices. The consumer will not buy anything unless it is on sale (price reduction). For example, I will not buy a new automobile unless there is $3000 rebate and zero percent financing.
3. Reduction in investment value or liquidity in the market. For example, the stock market or real estate has a significant decrease in value, and consumers have less money to spend. For example, the home owner can no longer use his house as an ATM (take out money) because its value has decreased. He can’t go buy a new BMW by refinancing his house.
4. Bank credit deflation. Reduced availability of bank credit because of new rules regarding credit worthiness, the high bankruptcy rate, and central bank policies can make it more difficult for businesses and consumers to get loans. I cannot get a loan to buy a new automobile, house or start a small business. A corporation cannot get a loan to buy capital equipment. This can spur the decrease of the price of goods.
5. Reduction in government spending. For example, the federal government has to decrease spending on goods because its debt load (payments) makes up an increasing part of the budget. There is also a reduction in tax collection (the unemployed/underemployed pay less taxes, spend less on taxable goods, etc.) The resulting decrease in demand for goods feeds into a downward trend in prices. For example, states’ budgets have decreased because of lower tax collection, which can drive down the price of goods and services, and in turn drives unemployment higher.
The best investments for periods of deflation are the following:
1. Medium to long duration bonds. The Feds may reduce interest rates with the intention of stimulating the economy; this would drive up the value of a bond as interest rates decline. (Paradoxically, while this is usually one of the best investments for deflation, it would not work well now with interest rates at historic lows.)
2. Currencies, stock or assets of countries that do not have deflation. If you own assets or currencies in countries that do not have deflation, your assets will increase against the currency decreasing. For example, if you own the currency of Brazil which does not have deflation, you will have more money to purchase assets in the US.
3. Short Equities. During deflation companies have decreasing revenue and lower margins. This usually leads to decreasing stock prices for the majority of stocks. You could use ETFs to short or leverage short (i.e. 3X short) the market. For example, you could short the S&P 500 using ProShares Short S&P500 ETF (SP) or leverage short the S&P 500 using ProShares UltraShort S&P500 ETF (SDS).
4. Short leverage assets (for example real estate). As prices collapse the value of the asset will continue to decline. You will want to short any company or asset that is highly leveraged. The value of the asset will continue to unwind and companies or assets that are highly leveraged will continue to decrease in value.
5. Cash is king. You want to raise cash and have less debt. Assets will decrease over time and will become cheaper. If you have cash you will be able to buy a lot of assets at reduced prices.
6. High paying annuities. If you can lock in a high paying annuity it will continue to pay cash as interest rates decline and the value of the annuity will increase.
The worst investments for deflation are the following:
1. Highly leveraged assets. As the value of an asset is decreasing, it gets more costly to pay the debt. This is the worst investment that you can be in during deflation. For example, you own a house that is 100% financed, the value of the house is decreasing and it is more costly to pay the debt (woe to you if you will not be getting a raise or if your pay actually decreases!). You do not want to be forced to sell assets to generate cash during deflation.
2. Debt. Any debt will be more costly to pay off during deflation. Remember cash is king in deflation periods. If you have cash you can buy a lot of reduced cost assets.
3. Long Stock. You have to be very selective in the stocks you buy. There will be revenue, profit and margin pressure during deflation which will drive down stock prices. Companies that are highly leveraged (have a lot of debt) will not be good investments (it is more difficult to pay for debt when there is deflation).
Please add your insight. For example, when will the US have inflation or deflation? I would like to have an on-going discussion of financial and investing ideas.
Next week, I will write about when I think we will have inflation, deflation or stagflation. Future topics may include:
- What investments will be good investments with rising inflation and interest rates?
- Warning signs of inflation or deflation
- Shorting US currencies
- What sector will do the best in 2010?
- Update on performance of blog trades
- Financial rules / lessons (school of hard knocks)
- Other topics
In April I will be starting a financial website (www.paulsgang.com) and in the summer I will be kicking off a financial podcast with Fullstacks, Mr. C and C4.
© 2010 Paul Cusick
My favorite financial books that I have read in the last 3 months:
The Ascent of Money: A Financial History of the World
The Greatest Trade Ever: The Behind-the-Scenes Story of How John Paulson Defied Wall Street and Made Financial History
The Big Short: Inside the Doomsday Machine
Paul
Saturday, March 20, 2010
Inflation / Deflation
This week I am starting a series of blogs on inflation and deflation and what are good / bad investments for those conditions. This week will be focused on inflation and hyperinflation.
Definition of inflation from Yahoo Education: “A persistent increase in the level of consumer prices or a persistent decline in the purchasing power of money, caused by an increase in available currency and credit beyond the proportion of available goods and services.”
Definition of hyperinflation from Yahoo Education: “Extremely high monetary inflation.”
Definition of deflation from Yahoo Education: “A persistent decrease in the level of consumer prices or a persistent increase in the purchasing power of money because of a reduction in available currency and credit.”
Inflation is caused by the following:
1. Money supply grows faster than the rate of potential output of the economy, or real GDP. This, combined with low interest rates, can eventually lead to unsustainable levels of growth as cheap money is available. In the long term this will cause inflation. The Fed will increase the money supply because they are lenders of the last resort. If the federal deficit keeps increasing and there are not enough buyers of the debt (or if the Fed wants to keep interest rates low), the Fed will need to buy the debt by printing more money and adding it to the money supply.
2. Rise in production cost of goods. For example, increases in raw materials and / or increases in labor cost.
3. Change in availability of supplies. The Arab Oil embargo of the mid 1970s is a classic example of change in availability of supply. This caused an increase in the price of gas, paint, and petroleum based products. This was one of the major causes of the mid 70s to early 80s inflation period.
4. The consumer demands more goods and services than are available. This can lead to the seller increasing the price of the good or service and driving up inflation.
5. Inflation can be artificially created through a circular demand by workers to increase wages (for example, when a change in supply increases cost of goods) which causes an increase in production costs which will increase prices that will lead to further demands of higher wages. You do not want to be on a fixed income when this happens.
The main cause of hyperinflation is the Fed printing money at a much faster rate than the growth of GNP. A great example of this is post World War I Germany.
The best investments for inflation or hyperinflation are the following:
1. Commodities, precious metals or gold (see blogs Gold – January 3, 2010 and Natural Gas – February 8, 2010). You could use Mutual Funds, Exchange Traded Funds (ETF) or commodity producing and / or mining company stocks for investment in commodities, precious metals or gold.
2. Real estate. This could include personal or income property (with a fixed rate mortgage) or Real Estate Investment Trust (REITS). In Germany during the post World War I period of hyperinflation, a home owner could not find his banker to pay off his mortgage because he could have paid it off with one day of salary. You want to own a lot of leveraged assets when there is hyperinflation.
3. Foreign stock or currencies of countries which do not have inflation or hyperinflation. For example, if the BRIC countries (Brazil, Russia, India, and China) do not have inflation or hyperinflation you could use BRIC ETFs for foreign stock investing (see blog BRIC ETFs … - January 13, 2010).
4. Very short term CD or Treasury securities if you need cash for future investments or for cash flow.
5. Shorting US currency and US treasury or long term bonds (if interest rates also increase) (see blog … Shorting US Treasuries - January 13, 2010).
The worst investments for inflation or hyperinflation are the following:
1. Investments in cash. For example, CDs, saving accounts, etc.
2. Long or medium maturity duration bonds (see blog Bonds – February 27, 2010).
3. Long term fixed rate annuities or anything that pays a fixed income.
Next week, I will write about what causes deflation and investments for deflation.
Future topics may include:
- What investments will be good investments with rising inflation and interest rates?
- Prediction when we will have inflation or deflation
- Warning signs of inflation or deflation
- Shorting US currencies
- What sector will do the best in 2010?
- Update on performance of blog trades
- Financial rules / lessons (school of hard knocks)
- Other topics
In April I will be starting a financial website (www.paulsgang.com) and in the summer I will be kicking off a financial podcast with Fullstacks, Mr. C and C4.
Please add your insight. For example, when will the US have inflation or deflation?
I would like to have an on-going discussion of financial and investing ideas.
© 2010 Paul Cusick
Paul
Definition of inflation from Yahoo Education: “A persistent increase in the level of consumer prices or a persistent decline in the purchasing power of money, caused by an increase in available currency and credit beyond the proportion of available goods and services.”
Definition of hyperinflation from Yahoo Education: “Extremely high monetary inflation.”
Definition of deflation from Yahoo Education: “A persistent decrease in the level of consumer prices or a persistent increase in the purchasing power of money because of a reduction in available currency and credit.”
Inflation is caused by the following:
1. Money supply grows faster than the rate of potential output of the economy, or real GDP. This, combined with low interest rates, can eventually lead to unsustainable levels of growth as cheap money is available. In the long term this will cause inflation. The Fed will increase the money supply because they are lenders of the last resort. If the federal deficit keeps increasing and there are not enough buyers of the debt (or if the Fed wants to keep interest rates low), the Fed will need to buy the debt by printing more money and adding it to the money supply.
2. Rise in production cost of goods. For example, increases in raw materials and / or increases in labor cost.
3. Change in availability of supplies. The Arab Oil embargo of the mid 1970s is a classic example of change in availability of supply. This caused an increase in the price of gas, paint, and petroleum based products. This was one of the major causes of the mid 70s to early 80s inflation period.
4. The consumer demands more goods and services than are available. This can lead to the seller increasing the price of the good or service and driving up inflation.
5. Inflation can be artificially created through a circular demand by workers to increase wages (for example, when a change in supply increases cost of goods) which causes an increase in production costs which will increase prices that will lead to further demands of higher wages. You do not want to be on a fixed income when this happens.
The main cause of hyperinflation is the Fed printing money at a much faster rate than the growth of GNP. A great example of this is post World War I Germany.
The best investments for inflation or hyperinflation are the following:
1. Commodities, precious metals or gold (see blogs Gold – January 3, 2010 and Natural Gas – February 8, 2010). You could use Mutual Funds, Exchange Traded Funds (ETF) or commodity producing and / or mining company stocks for investment in commodities, precious metals or gold.
2. Real estate. This could include personal or income property (with a fixed rate mortgage) or Real Estate Investment Trust (REITS). In Germany during the post World War I period of hyperinflation, a home owner could not find his banker to pay off his mortgage because he could have paid it off with one day of salary. You want to own a lot of leveraged assets when there is hyperinflation.
3. Foreign stock or currencies of countries which do not have inflation or hyperinflation. For example, if the BRIC countries (Brazil, Russia, India, and China) do not have inflation or hyperinflation you could use BRIC ETFs for foreign stock investing (see blog BRIC ETFs … - January 13, 2010).
4. Very short term CD or Treasury securities if you need cash for future investments or for cash flow.
5. Shorting US currency and US treasury or long term bonds (if interest rates also increase) (see blog … Shorting US Treasuries - January 13, 2010).
The worst investments for inflation or hyperinflation are the following:
1. Investments in cash. For example, CDs, saving accounts, etc.
2. Long or medium maturity duration bonds (see blog Bonds – February 27, 2010).
3. Long term fixed rate annuities or anything that pays a fixed income.
Next week, I will write about what causes deflation and investments for deflation.
Future topics may include:
- What investments will be good investments with rising inflation and interest rates?
- Prediction when we will have inflation or deflation
- Warning signs of inflation or deflation
- Shorting US currencies
- What sector will do the best in 2010?
- Update on performance of blog trades
- Financial rules / lessons (school of hard knocks)
- Other topics
In April I will be starting a financial website (www.paulsgang.com) and in the summer I will be kicking off a financial podcast with Fullstacks, Mr. C and C4.
Please add your insight. For example, when will the US have inflation or deflation?
I would like to have an on-going discussion of financial and investing ideas.
© 2010 Paul Cusick
Paul
Sunday, March 7, 2010
Zero Coupon Bonds
This blog is going to be another short and ‘sweet’ one. I just completed my taxes and I am starting to work on my oldest son’s college financial documents this week. I will have limited time to work on my blog and will continue to write some short blogs on bonds investing. Today I’ll talk about zero coupon bonds.
Last blog (dated February 28th) I talked about zero coupon bonds and average bond duration. Zero coupon bonds are the only type of bonds for which maturity equals the duration. For example if the zero coupon bond maturity is 10 years the duration will be 10 years. What are bond coupons and zero coupon bonds? The term bond coupons came about when bonds were historically issued as bearer certificates - if you had possession of the certificate, you were considered the owner of the bond. Coupons were attached to the bond, for example if the bond maturity was 10 years and the interest was paid once a year you would have ten coupons for each interest payment. At the due date you would cut the coupon from the bond and present it for payment. Zero coupon bonds have no coupons; you buy the bond for less than the face value and get repaid the face value at time of maturity. There are no yearly interest payments. For example, if you paid $750 for a bond that has a face value of $1000 and maturity of 5 years, you will be paid $1000 after five years.
Zero coupon bonds have interesting US tax consequences. Even if the bond holder does not get interest payments every year the IRS requires you that you “impute” an interest income every year and report this income every year on your income tax statement. Usually the issuer will send you a 1099 form. If you are interested you can get information on zero coupon bonds and tax consequences from the IRS Publication 17: http://www.irs.gov/publications/p17/. You could buy zero coupon bonds in your tax exempt account (i.e. IRA) and have no tax consequences.
The largest categories of zero coupon bonds are the following:
• Treasury securities
• Zero coupon corporate bonds
• Zero coupon municipal bonds
• Saving bonds
Treasury and municipal bonds also have interesting US tax consequences. Holders of municipal bonds may not have to pay local, state or federal taxes (this makes it cheaper for municipalities to fund projects since the interest rate will be lower than the market rate). Treasury bond holders may not have to pay local or state taxes either. Please review IRS publication 17 or talk with your tax accountant about the tax consequences of buying these bonds. If you are interested in calculating tax-free vs. taxable yield comparisons, you can use the following calculator: http://www.investinginbonds.com/calcs/taxcalculator/taxcalcform.aspx. Using the calculator and selecting my state, taxable income and filing status, I learned that if a municipal bond has a 3% tax free yield, the equivalent taxable yield would be 4.61%. This is a very simple tool for calculating yield for tax free bonds.
Zero coupon bonds may be a good alternative if you are working to a specific time frame such as a child's college tuition payments or your retirement, and if you intend to hold the bonds until maturity. For example, if the interest rate is 7%, maturity is 20 years and the face value is $20,000 you will pay around $5,050 for the bond and receive $20,000 when it matures in 20 years. The beauty is it’s very predictable; you pay $5,050 and receive $20,000 in 20 years.
Investors also buy treasury zero coupon bonds because they are very safe - they are backed by the full faith of the US government and treasury (the treasury can always print money to pay the bond holders). Zero coupon bonds have the same interest rate risk as all bonds and, if you need the cash flow, you can always sell the bond on the secondary market.
Next week, I will write about when I think inflation and interest rates may go up and why. I’ll also address what investments will be good investments with rising inflation and interest rates. Future topics may include:
- Shorting US currencies
- What sector will do the best in 2010?
- Update on performance of blog trades
- Financial rules / lessons (school of hard knocks)
- Other topics
In April I will be starting a financial website (www.paulsgang.com) and in the summer I will be kicking off a financial podcast with Fullstacks, Mr. C and C4.
Please add your insight. I would like to have an on-going discussion of financial and investing ideas.
Paul
Last blog (dated February 28th) I talked about zero coupon bonds and average bond duration. Zero coupon bonds are the only type of bonds for which maturity equals the duration. For example if the zero coupon bond maturity is 10 years the duration will be 10 years. What are bond coupons and zero coupon bonds? The term bond coupons came about when bonds were historically issued as bearer certificates - if you had possession of the certificate, you were considered the owner of the bond. Coupons were attached to the bond, for example if the bond maturity was 10 years and the interest was paid once a year you would have ten coupons for each interest payment. At the due date you would cut the coupon from the bond and present it for payment. Zero coupon bonds have no coupons; you buy the bond for less than the face value and get repaid the face value at time of maturity. There are no yearly interest payments. For example, if you paid $750 for a bond that has a face value of $1000 and maturity of 5 years, you will be paid $1000 after five years.
Zero coupon bonds have interesting US tax consequences. Even if the bond holder does not get interest payments every year the IRS requires you that you “impute” an interest income every year and report this income every year on your income tax statement. Usually the issuer will send you a 1099 form. If you are interested you can get information on zero coupon bonds and tax consequences from the IRS Publication 17: http://www.irs.gov/publications/p17/. You could buy zero coupon bonds in your tax exempt account (i.e. IRA) and have no tax consequences.
The largest categories of zero coupon bonds are the following:
• Treasury securities
• Zero coupon corporate bonds
• Zero coupon municipal bonds
• Saving bonds
Treasury and municipal bonds also have interesting US tax consequences. Holders of municipal bonds may not have to pay local, state or federal taxes (this makes it cheaper for municipalities to fund projects since the interest rate will be lower than the market rate). Treasury bond holders may not have to pay local or state taxes either. Please review IRS publication 17 or talk with your tax accountant about the tax consequences of buying these bonds. If you are interested in calculating tax-free vs. taxable yield comparisons, you can use the following calculator: http://www.investinginbonds.com/calcs/taxcalculator/taxcalcform.aspx. Using the calculator and selecting my state, taxable income and filing status, I learned that if a municipal bond has a 3% tax free yield, the equivalent taxable yield would be 4.61%. This is a very simple tool for calculating yield for tax free bonds.
Zero coupon bonds may be a good alternative if you are working to a specific time frame such as a child's college tuition payments or your retirement, and if you intend to hold the bonds until maturity. For example, if the interest rate is 7%, maturity is 20 years and the face value is $20,000 you will pay around $5,050 for the bond and receive $20,000 when it matures in 20 years. The beauty is it’s very predictable; you pay $5,050 and receive $20,000 in 20 years.
Investors also buy treasury zero coupon bonds because they are very safe - they are backed by the full faith of the US government and treasury (the treasury can always print money to pay the bond holders). Zero coupon bonds have the same interest rate risk as all bonds and, if you need the cash flow, you can always sell the bond on the secondary market.
Next week, I will write about when I think inflation and interest rates may go up and why. I’ll also address what investments will be good investments with rising inflation and interest rates. Future topics may include:
- Shorting US currencies
- What sector will do the best in 2010?
- Update on performance of blog trades
- Financial rules / lessons (school of hard knocks)
- Other topics
In April I will be starting a financial website (www.paulsgang.com) and in the summer I will be kicking off a financial podcast with Fullstacks, Mr. C and C4.
Please add your insight. I would like to have an on-going discussion of financial and investing ideas.
Paul
Subscribe to:
Posts (Atom)
Posts
