August 6, 2014

Inflation Adjusted Bond Prices Tell Different Story on Relative Value

By EconMatters  

One of the arguments for why US Bonds are such an attractive investment even at these low yields is that relative to European Bonds the US Treasuries provide such a higher yield, but this analysis is shortsighted because it fails to take into account the factor of inflation. Once you adjust yields based upon inflation it tells investors an entirely different story in regards to relative value of bonds and the comparison is different between European and US Bonds.

For example take the German 10-Year bond at 1.15% Yield versus the US 10-Year Bond with a yield of 2.47%; well the argument goes why would I invest in the German Bond relative to the US Bond when the yield is so much greater? But investors need to remember to factor in inflation levels, so the German yield minus Eurozone annual inflation of 0.4%, remember it isn`t Germany`s inflation which is higher but still under 1% annualized, it is the Eurozone since they share the currency of the Euro that is important here, so we get 1.15% minus 0.4% for an inflation adjusted yield of 0.75% or 75 basis points. Now contrast the US 10-Year Bond with a Yield of 2.47% minus an annual inflation rate of 2.1% and we get an inflation adjusted yield of 0.37% yield or 37 basis points.
Under this analysis the German 10-Year inflation adjusted yield is 38 more basis points than the US equivalent 10-year, so this throws a bunch of cold water on the notion that US Treasuries are such a yield bargain for investors compared to European bonds. 

In fact, considering the US inflation rate is probably much higher than the numbers are actually detailing in the watered down inflation metrics used to track inflation by the government due to a number of factors, and it is rising on an upward trend the US 10-Year yield probably needs to rise against the German 10-year, as it is even more out of whack once you factor in the future growth prospects of the two economies. 

So as the previous theory went regarding relative value of the two bonds, and the trade being to short German bonds [short price long yield] and buy US bonds [long price and short yield] on a spread trade. Actually if we were going by the inflation adjusted return fundamentals we should be shorting US Bonds [short price long yield] and Buying German Bonds [long price short yield] for a spread arbitrage yield value trade. Remember yields go in the opposite direction of bond prices to fully wrap your head around the trade. 
I don`t recommend this as theory is different in financial markets than making money, but this hypothetical spread trade was just to illustrate how investors often choose investment vehicles or make trades based upon faulty assumptions, and once one accounts for inflation, there are a lot of investors talking about relational values of bonds that are actually the exact opposite of what rationale they are using to base their investment decisions. 

Therefore, by my calculation the US 10-YEAR Yield is not that attractive relative to European Bond Yields, in fact US bonds are downright expensive in terms of price versus the inflation adjusted yield I am getting as an investor. Remember one has to invest using the same currency that the bonds are purchased in, and thus inflation adjusted returns matter in this case when evaluating relative value and real returns.


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