Sunday, March 18

Week 37 - Hedging Your Bets

Situation: We have noticed a common misunderstanding on the part of both novice and seasoned investors: Too frequently a “hedge” for an investment is expected to make money for the investor, at least enough to cover trading costs and inflation. However, Merriam-Webster’s Collegiate Dictionary (11th ed) defines a hedge otherwise: “to protect oneself from losing or failing by a counterbalancing action.” A hedge may serve its purpose yet still be very expensive. But it can’t be so expensive as to obviate the purpose of acquiring it. An investment is designed to show a profit after costs for transactions, inflation, & taxes are paid. Hedges are not.

So let’s consider ITR’s favorite hedge (next to Savings Bonds). It was discussed in the Goldilocks Allocation blog (Week 3): 10-yr US Treasury Notes. Lately our fave has been getting a lot of bad press since it currently pays 2%, while the Consumer Price Index sets the rate of inflation at almost 3%. This situation is upside-down and quite uncommon in our country’s history. It has occurred because the Federal Reserve has adopted a policy of driving interest rates so low that people choose to make risky investments in the economy. This policy is known as “Financial Repression.” In other words, you can do better today by using your money for higher risk situations than by purchasing US Treasury bonds. If you have spare cash it is better to become an entrepreneur, buy stock, or buy something expensive (i.e., because inflation is expected to return soon). The last time the Federal Reserve adopted a policy of Financial Repression was in 1949. These monetary actions also have the not inconvenient feature of making it very cheap for the US Treasury to borrow money. An economics professor will tell you that such a policy risks producing the opposite outcome (i.e., hyperinflation) at some point in the not too distant future. That didn’t happen in 1949 for the singular reason that there was a great amount of “excess slack” in the economy due to the ending of World War II. Chairman Bernanke at the Federal Reserve has said that excess slack also characterizes our present economy, thus he is not very worried about hyperinflation.

In the present (unusual) situation, owning US Treasury Notes & Bonds does not appear to be useful as a hedge against collapsing stock prices. However, in August 2008 and August 2011 it was very useful. In August 2008, a new 30-yr T-Bond paid 4.5% interest. Now a new T-Bond pays 3% interest. That means the T-Bond you bought in August 2008 has gained 50% in value. If you paid $1000 for that bond, you could get ~$1500 for it now. While 10-yr T-Notes don’t go up as much during a recession, they also don’t go down as much when risky investments like stocks soar in value. But the important point is to build up a store of T-Notes over time because in a Bear Market for stocks those T-Notes are worth a lot more money than you paid for them. And here’s another important point--only a fool tries to predict the direction interest rates will move. That means that you would be wise to bite the bullet and make a regular quarterly payment into your hedge, whatever it may be. We favor T-Notes & inflation-protected Savings Bonds (ISBs). Others favor T-Bonds, while the rich who have no fear of losing their shirt freely invest in raw commodities (gold bricks, oil sitting in tankers moored off the coast of Singapore, etc.). 

Let’s take a look at how 10-yr US Treasury Notes function as a hedge--by taking the very long view. Since 1953, the AVERAGE interest rate on those Notes has been 6.2% according to Jack Hough (WSJ, 3/3/12 “Where to Find the Bargains”). Inflation has been 3.7% over that 59-year period as per the Consumer Price Index. If treasurydirect had been available in January 1953 and you had made a cost-free $100 investment in a 10-yr US Treasury Note paying 6.2% interest, you would have received $3,378 in interest over the next 59 yrs. This assumes that the note was “rolled over” every 10 yrs into a new Note paying the same interest. 

Now, consider that if the US Treasury had a dividend re-investment plan (DRIP) to go along with the $100 investment in bonds, every bi-annual interest payment of $3.10 would have become a re-investment--in a fractional share of a new Treasury Note paying 6.2%. Let’s say you continued spending $100 every January on the same investment and it continued to pay the same average 6.2%/yr. Those annual $100 investments would have produced $51,964 of interest payments over 59 years (total return = 5.2%/yr). You would have paid ~$15,000 in Federal tax (no state or local tax) and lost ~$37,000 to inflation. So where does our T-Note investment stand?? This hedge would have cost you nothing and profited you nothing after accounting for all costs (transaction fees, inflation, and taxes). 

Since we don’t have US Treasury Notes that pay 6.2% today, it’s hard to get cozy with the information in the above paragraph. We just have to take a deep breath and understand:
   a) Financial Repression is temporary;
   b) Interest rate cycles have very long durations (our current cycle peaked in 1982), so data has to be averaged across an entire cycle to have any meaning; 
   c) Dollar-cost averaging T-Notes over your adult life will allow you to capture the benefits and terrors of the cycle you’re living. It’s important to get in the habit of maintaining about 5% of your assets in the form of T-Notes purchased regularly at treasurydirect in multiples of $100.

Remember, when the stock market tanks the value of T-Notes increases dramatically. Two recent examples of this increase in value were a) after Lehman Brothers went belly-up, and b) in the past few months when it looked like the European Union might fall apart. There is no rational replacement for T-Notes and T-Bonds as a hedge against a Bear Market in stocks. Raw commodities could do the trick but they’re expensive to store and insure, and carry real risk. Commodities can lose 50% of value very quickly if a recession turns into a depression. When that happens, only T-Notes and T-Bonds will soar upward in value. By that point, newly purchased T-Notes/Bonds will be paying very low interest so you can’t be late to the party! Take a lesson from the biblical Joseph!! Remember him? The guy who stuck valuable grain in a storehouse knowing that in the next drought cycle it would be worth a bundle.

Bottom Line: A well-chosen hedge not only serves its purpose (conservation of assets) but will cost you nothing over the long-term. By dollar-cost averaging, your investment in 10-yr Treasury Notes probably won’t lose or gain any money over an interest rate cycle. But in a Bear Market your accumulated T-Notes will likely be worth at least 10% more than you paid for them. As we’ve seen recently, Bear Markets are associated with high unemployment--another painful reason why those T-Notes might come in handy.

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