Saturday, July 23, 2005

Bonds and Real Returns

From 1926 to today, inflation has averaged about 3% per year. In order to stay even with the inflation an investor must earn after tax return of 3% each year. If you are in top most tax bracket, then the income from bonds is currently taxed at 35%.

The 10-year bond currently yields 4.21%. After paying 35% tax on this income, this investor will earn 2.73% return over the 10-year period. In real terms, the investor will lose 0.27% to inflation.

The 30-year bond has the yield of 4.43%. After paying 35% tax on this bond income, the investor will earn 2.87% return over the 30-year period. In real terms, the investor will lose about 0.13% annually to inflation.

In today’s low rate environment, bonds do not provide a real return. Some may argue that the inflation will not average 3% for the next 30-years, the market is not expecting it. Precisely. The market rarely accommodates the majority. The inflation expectations are too low today. Be prepare for a surprise.

All disclaimers apply.


Chris said...

That's an interesting point. Over at InvestorGeeks we're starting a new series on bond basics. I'd be interested to get your feedback.

Anonymous said...

If you keep the bond portion of your asset allocation in a tax sheltered account (like a 401k) then you'll beat inflation. Also, tax free municipal bonds are currently paying 4%.