lower a government bonds current value, the more it will grow until maturity. An old joke asks, whats the difference between men and bonds? The answer is that bonds eventually mature. Not only do all U.S. government bonds mature, they mature exactly on schedule and at a price of exactly $100. Thus, the lower the current price of a U.S. government bond, the more gains to the eventual price at maturity of $100. Lower bond prices mean higher future returns. Similarly, higher bond prices mean lower future returns.

When interest rates go up, bond prices go down. When interest rates go down, bond prices go up.

Another way to look at bonds is to divide current owners from possible buyers in the future. If, for example, home prices were to plummet, that would be bad for current homeowners but good for future buyers. Similarly, a drop in bond prices is bad for current bond owners, but good for future bond buyers.

The decision to invest in bonds rests upon a prediction about the direction of interest rates. Buyers of bonds are betting that interest rates will remain stable or decline. Those who believe interest rates will rise should avoid owning bonds. Accordingly, the mission of this chapter is to examine the future of U.S. interest rates.

Revenge of the Bond Wimps

In 1993, Professor Mankiw said bonds were for wimps because the economic research suggested that brave investors ought buy stocks.

While bonds may be for wimps, those wimps who bought bonds in 1993 had very good outcomes-perhaps better than if they had bought stocks. In the time since the bonds are for wimps statement, the total amount earned from buying U.S. Treasury bonds has been almost the same as from buying stocks. Furthermore, those who bought bonds knew that the U.S. federal government would pay them back. Stock owners took big risks, which included two consecutive years of serious stock market declines.

In recent decades, bonds have been the profitable tortoises to the profligate hares of the stock market. In fact, the good years to have bought bonds started in the early 1980s, more than 10 years before Professor Mankiw said bonds were for wimps. Interest rates over the last 20-plus years have seen a persistent and powerful decline (see Figure 7.1). Accordingly, bond owners have been handsomely rewarded for more than 20 years.

I remember reading a magazine article in the early 1980s that suggested buying what it labeled the Reagan bonds. These were long-term U.S. government bonds with interest rates significantly above 10%. I took note of the argument neither because I believed it nor because I was going to buy the Reagan bonds. I took note because the article seemed so ridiculous.

Consistent with the theme of this book, bonds were a great buy at precisely the time they were hated. In the late 1970s and early 1980s, the hot investment themes were real assets, including gold, jewels, land, and impressionist paintings. In a time of inflation, everyone knew that bonds were for idiots (and probably wimpy idiots at that).

FIGURE 7.1 20+ Years of Declining Interest Rates and Rising Bond Prices

Source: Federal Reserve

Over the last 20 years-since the time that bonds were hated-bond investors have had the best of all imaginable investment worlds. They have enjoyed high returns and low risk. Fantastic. Is this trend likely to continue?

The Mother of All Deficits: Eating Up the Worlds Savings?

In an episode of The Simpsons our hero Homer Simpson is sent to hell. His somewhat innovative torture is to be forced to eat donuts until it becomes excruciating. Accordingly, the devils workers collect all the donuts in the world, which they stuff one after another into Homers mouth. Far from being unhappy, however, Homer eats every donut in the world and still wants more.

There is a similar specter haunting the bond market; it is the voracious U.S. federal budget deficit. If, like Homer Simpson, the U.S. government eats up all the available credit, what will be left for homeowners and businesses? If there is not enough money to be borrowed at low interest rates, then large budget deficits might cause interest rates to rise.

There are indeed reasons to be afraid of the U.S. budget deficit as it is forcing the U.S. government to borrow an additional billion and half dollars a day. Former U.S. Senator Dirksen (who died in 1969) is reported to have said: A billion here, a billion there, and pretty soon youre talking real money. While there is no written evidence that the senator actually made this statement, $1.5 billion a day (including weekends) is definitely real money.

The problem with large deficits is that they eat up the supply of credit or crowd out private investments. Heres how James Tobin, Yale professor and winner of the Nobel Prize in Economics, described the problem: