Your purchasing power is your lifeblood in retirement. On my office credenza is The Theory of Investment Value by John Burr Williams, first published in 1937. Chapter five is titled “Evaluation by the Rule of Present Worth, Section I. Future Dividends, Coupons, and Principal.” Burr writes:
[D]ividends, or coupons and principal, must be adjusted for expected changes in the purchasing power of money. The purchase of a stock or bond, like other transactions which give rise to the phenomenon of interest, represents the exchange of present goods for future goods—dividends, or coupons and principal, in this case being the claim on future goods. To appraise the investment value, then, it is necessary to estimate the future payments. The annuity of payments, adjusted for changes in the value of money itself, may then be discounted at the pure interest rate demanded by the investor.
This month, Moody’s downgraded Illinois’s state debt from A1 to A2, thereby increasing its borrowing costs on $800 million in 10-year general obligation bonds by 110 basis points to 3.1%. You have to wonder whether you’d like to partner with this state, or any state for that matter. Illinois bondholders who need to raise cash in a hurry may not like what rising interest rates do to their principal value.
For stocks, getting a juicy dividend is one thing; seeing that stock pay you the dividend year in and year out is another. Burr would ask, is there leverage being used to prop it up? Is the payout ratio sustainable? What is the government risk? All of these questions were as relevant in 1937 as they are today.
Last week, headline inflation came in at 3.0%, with food up to 4.7% and energy down to 6.6%. If inflation really kicks in, those juicy dividends may not have much cash left in the tank to keep pace. Bond coupons may be negative in real terms if swallowed up by inflation. Having some flexibility to work the yield curve will come in handy. And dividends, coupons, and principal must be adjusted for expected changes in the purchasing power of money.