Thing to Keep in Mind Is What You End Up Keeping

By TOM PETRUNO

Sept. 29, 1996 12 AM PT

At least this time, the line “We’re from the federal government and we’re here to help” doesn’t sound like such an oxymoron.

The case in point: The “inflation-protection” Treasury bonds unveiled by President Clinton last week and set to be sold quarterly, beginning in January.

The idea is to guarantee the buyers of these bonds against the potential loss of purchasing power caused by inflation--something the Treasury has never done before, although such bonds have been issued by Britain, Canada and Australia, among other countries.

Despite Clinton’s hyperbole about the bonds being a “solid rock upon which families build their dreams,” these securities won’t be a panacea. In fact, if the next 10 years are at all like the last 10 in terms of the inflation rate and financial markets’ performance, inflation-protection bonds will be a pretty dull investment compared with other options, including traditional Treasury bonds.

Nonetheless, the government’s decision to offer these new bonds is a great service to individual investors for one major reason: It forces people to realize that, in investing, it’s not what you earn--it’s what you keep.

Too many investors, novice and experienced, get caught up in the hunt for high nominal returns and fail to focus on the real returns they’re left with after accounting for three very key costs: inflation, taxes and investment expenses (commissions, fees, etc.).

Inflation may be the cost that investors think of the least today, because general price increases in the U.S. economy have been relatively tame for most of the last five years. Moreover, inflation has come down worldwide over the last few years, a function of the increasingly competitive global economy and the almost universal drive for efficiency in business.

This year there has been a small uptick in U.S. inflation, mainly because of higher food and energy costs. Even so, the consumer price index tracked by the government has risen about 3% or slightly less for each of the last six years--making this the longest stretch of such low inflation since the early 1960s.

Let’s say we’re lucky and price inflation remains relatively quiescent for the next 10 years, in the range of 3% a year.

Not a big deal for investors? That depends on what you consider significant purchasing power lost.

As the accompanying table shows, even at 3% a year, inflation exacts a high toll over 10 years. A basket of goods that now costs $1,000 would cost $1,340 after a decade of 3% inflation. To put it another way, your nest egg’s purchasing power would erode by a full third over 10 years if you just kept those dollars in a mattress.

Of course, most people don’t stuff their mattress--they save or invest their money. But probably too few investors think about the fact that inflation is really an ever-present hurdle: You have to at least beat inflation with your investment returns before you can even think about getting ahead of the game and living better.

That obviously hasn’t been a problem for most stock and bond investors over the last 15 years. Returns have been so good, and inflation so controlled, that the inflation hurdle has been like a pebble on the sidewalk.

But it hasn’t always been so. A major reason why veteran bond investors are so paranoid today about any hint of higher inflation is that they remember the 1970s and what soaring inflation in that decade did to bonds.

Consider: If you bought a 10-year Treasury note for $1,000 in early 1971, the interest yield you would have locked in for each of the next 10 years was 6%.

What those investors couldn’t foresee was the oil crisis of the mid-1970s and what that would mean for inflation. In 1971, the consumer price index rose 3.3%, which means the real, after-inflation return on a 6% Treasury note that year was 2.7%.

But in 1973, with the oil crisis unfolding, inflation soared to 8.7%. So the poor investors stuck with 6% bonds earned 2.7 percentage points less than inflation--or as Wall Street is fond of saying in the vernacular, they had a negative real return of 2.7%.

Things got worse for those 6% bond owners in 1974, when inflation zoomed to 12.3%. And from that year through 1981, in only one year did a 6% yield beat the inflation rate. The result: By 1981, when that 10-year note matured, the purchasing power of the investor’s original $1,000 principal was slashed by more than 50%.

With the Treasury’s new inflation-protection bonds, that couldn’t happen again. Uncle Sam will guarantee a positive real return, no matter how high inflation goes. How? Each year, the Treasury will raise the bonds’ principal value by however much the consumer price index rises.

You don’t get something for nothing, however: The actual interest yield on the new bonds is expected to be far below current market yields. A traditional 10-year Treasury note now yields about 6.7% in annual interest. The inflation-protection notes (to be issued initially in 10-year maturities only) are expected to yield only 3% to 4% in actual annual interest.

But that interest yield will constitute your real return on the securities, and that’s what you have to use when comparing what you might earn on other investments. You’ll have to make a guess about inflation over the next 10 years and ask yourself whether the real, after-inflation return on traditional investments could be better than the probable 3% to 4% real annual return on the new bonds.

If inflation falls to 2% a year, on average, for the next decade, a traditional 10-year Treasury note yielding 6.7% would produce a real interest return of 4.7% a year--potentially much better than inflation-protection bonds’ yields and potentially more in total return even allowing for the inflation-protection bonds’ principal growth.

A recent study by J.P. Morgan & Co. looked at how inflation-protection bonds might have fared if the Treasury had begun issuing them in 1984. The study assumed that investors would have demanded a real, after-inflation return of 3.25% a year on the bonds.

Between 1984 and July of this year, that real return would have paled compared with the 12.1% average annual real return on blue-chip stocks in the period and the 6.9% annual real return on traditional Treasury bonds.

In fact, inflation-protection bonds’ 3.25% return would have been only slightly above the 2.75% real return on Treasury bills in the period.

What that tells you is simply that inflation-protection bonds are an insurance policy. Owning them alone would guarantee you’ll earn some relatively small real return over inflation. But to really live well off your nest egg in 10, 20 or 30 years, you’ll need to score some returns far above inflation. You can’t do that without taking higher risk in stocks and other non-protected investments.

The true value in the Treasury’s new securities is in focusing investors on what they keep, not what they earn. Thinking about inflation is the best starting point, but with every investment or savings vehicle you own, you should ask yourself: After inflation, taxes and investment expenses, what do I have left? And given that outcome, have I made the smartest choice?

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Inflation: Even a Little Hurts:

Price inflation has hovered 3% a year for most of this decade, a level that seems tame. But this table illustrates the challenge even alittle inflation presents over time. If inflation averages 3% a year over the next 10 years, for example, it will take $1,340 in 10 years to match the purchasing power of $1,000 today.

5 years:

Cost increase factor at average annual inflation of:

2%: 1.10

3%: 1.16

4%: 1.22

5%: 1.28

6%: 1.34

7%: 1.40

10 years:

Cost increase factor at average annual inflation of:

2%: 1.22

3%: 1.34