For decades, U.S. Treasurys have been considered a risk free asset. Today, Treasurys are an extremely risky asset, but not because of a possible default as often cited by the media.
When investors calculate possible returns on other investments such as stocks, they usually look at what the 10-year Treasury is yielding.
Legendary value investor David Dreman defines risk as the return on an asset after inflation. He rejects the mathematical formulas used by academics to measure risk.
Currently, the 10-year Treasury is yielding 2.15 percent. If someone invests $10,000, they will receive $215 a year for the next 10 years. The rate will not fluctuate, and therefore the total return will be $2,150 after 10 years.
This return is pretty mediocre, but when you take inflation into account, it is even worse. The average rate of inflation has been 3.24 percent from 1913-2011. If inflation averages the same amount over the next 10 years, that original $10,000 would be worth $7,445, meaning a loss of 25 percent. This calculation doesn't take into account taxes. The returns would be far lower since Treasurys are taxed both on a federal and state level.
But it gets even worse. Inflation is likely to be much higher in the coming decades. Federal Reserve Chairman Ben Bernanke has kept interest rates close to zero since 2008, and pledges to keep them at that level until mid-2013.
This is causing the dollar to decline and imports to increase in price. The result is that we are already seeing inflation in many staple goods like food and gasoline.
Some economists have even suggested that inflation is the best way to pay off our large federal deficit. If there is higher inflation, it will allow the U.S. government to pay off the debt with future dollars, which will be worth less than their current value.
Kenneth Rogoff, a distinguished economist and best-selling author, believes that the Federal Reserve should try to keep inflation between 4 percent to 6 percent over the next few years, in order to pay off our large federal deficit.
He believes this is the only way to avoid a Greek style situation in America.
Using a 6 percent inflation rate over the next ten years, $10,000 would be worth $5,584. After inflation, returns would be close to a 50 percent loss, before taxes; on a “risk free” asset!
Who in their right mind is buying 10 Treasurys with those numbers? The only way that people would make money is if there is no or little inflation, or deflation over the coming decade. This is a possibility, but highly unlikely.
Ignoring the whole downgrade issue, investors should think twice about how "safe" long-term Treasurys truly are.
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