Interest rate predictions make long-term Treasurys look bad

February 14, 2013

You have to love the Congressional Budget Office. In an era where spin has largely replaced substance in what passes for discourse in Washington, the nonpartisan CBO calls things as it sees them, regardless of the positions taken by other arms of the government.

Take the CBO’s interest rate projections, for example. If the numbers in the CBO’s recent semiannual budget update prove accurate, it means that there are at most only two years left of the Federal Reserve keeping interest rates ultra-low. The Fed has declined to provide a timetable for rates rising, but the CBO has indirectly given us one that has major implications.

Last month, I wrote that the Fed’s ultra-low-rate policies helped touch off what I called a behind-the-scenes currency war. It’s now become a public war, with many of our major trade partners trying to depress their currencies to stay competitive with us and with each other. If the CBO is right, the war could be coming to an end reasonably soon, which would be a good thing.

The CBO isn’t in the investment advisory business, but its interest rate projections are a clear warning to any yield-hungry investor tempted to buy the 10-year U.S. Treasury note, which currently yields about 2 percent. The rationale for buying this security is that 2 percent isn’t much, but it’s better than zero, the approximate rate you get from money market funds and short-term bank accounts these days.

But look out. If the CBO is right, you would be better off hiding your money under your mattress for the next two or three years than using it to buy a 10-year Treasury note today.

Think that’s crazy? Let me show you the numbers.

The CBO is predicting that 10-year Treasury notes — which, remember, are currently yielding 2 percent — will yield 3.2 percent in 2015, which is two years from now, and 4.1 percent in 2016.

Now, for the math. If you buy a 10-year Treasury today at face value, the interest you receive over its life will total 20 percent of what you put up: 2 percent a year for 10 years. But if the yield is 3.2 percent two years from now, you would be better off doing nothing for two years, buying the note at well below face value, and collecting 3.2 percent for eight years. That would produce 25.6 percent over eight years (8 times 3.2), a heckuva lot better than 20 percent over 10 years.

If the CBO is right and you wait three years to buy the note — at a steep discount — you would collect 4.1 percent for seven years, or a total of 28.7 percent on your money.

Unlike stock prices, which are often ruled by emotion, market prices of Treasury debt securities are ruled strictly by arithmetic. Consult a handy-dandy bond calculator like the one posted at SmartMoney.com and you’ll see that if you pay 100 cents on the dollar for a 10-year, 2 percent Treasury today and yields rise to 3.2 percent in two years, your note would be selling at only 91.65 percent of face value. In other words, your capital loss would more than offset the interest you had already collected, plus two more years worth. Your choice would be to take the loss all at once by selling, or take it over time by collecting only 2 percent while other investors are collecting 3.2 percent.

If rates are 4 percent three years from now, the now-seven-year note would sell at 88, wiping out six years of interest.

I’m not telling you that the CBO is right about interest rates. But if it’s even remotely right, the investment world will be a lot different in two or three years than it is now. By then, the currency wars may be a fading memory. And the people who put heavy money into long-term Treasury securities will be asking themselves that painful question: What was I thinking?

Sloan is Fortune magazine’s senior editor at large.

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