Treasury Bonds, compounding at new interest rates

Question

this is more a question about bonds in general than just Treasuries, but we will use Treasuries for example

Let say you have $10,000,000 and you buy 30-year Treasury bonds currently yielding 3% annually. If I understand this correctly, then every year that account will receive $300,000 dollars. Simply letting this accumulate over 30 years and the account will grow by $9,000,000. ($300,000 x 30) before receiving the original principle of $10,000,000 back.

The risk being that this might not keep up with inflation over 30 years.

Would this risk be mitigated if the $300,000 was reinvested into new Treasury Bonds at the then current interest rate - regardless of if the new interest rate is higher or lower than the initial treasury purchase?

Please explain thank you

Answer 1

Yes, this would mitigate the risk somewhat, though not by a huge amount. Remember, you only have the 3% to reinvest, plus of course whatever profit you can make from your reinvestment. Compared to keeping it in cash, which pays 0%, any reinvestment paying a positive return would be better.

If you expect Treasury bonds to pay more than 3% in future years, you may be better off using Dollar cost averaging. That is, do not invest the entire $10,000,000 in the first year, spread out your investments over a few years. Keep in mind, though, that any money not invested in the first year (and presumably kept as cash) would not receive any interest that year.

Answer 2

3% x 30 = 90%, but 3% compounded over 30 years will return 142.7%, a difference that's more than trivial. By getting a greater return, you stand a better chance of beating inflation than with the lower return.

Answer 3

As an inflation hedge, I don't think this is a good strategy.

The majority of your capital, the $10 million, is tied up in a fixed price investment - not desirable during an inflationary environment when prices are going up. At the end of 30 years you get $10 million back from the initial $10 million. If inflation averaged 3% over the 30 years the $10 million at the end of the 30 years would be worth around $4.1 million from your original investment. That's a substantial loss.

Yes, you will have some income from the interest payments from the bonds. Those payouts are small, however, compared to your original investment so the interest received from the reinvestment of this income back into bonds will not make up for the loss you will suffer on your initial capital. And again, you would be investing those interest payments back into a fixed price asset during an inflationary environment - not desirable.