Rightly or not, gold is widely viewed as an inflation hedge — a reliable measure of protection against purchasing power risk. The precious metal may not be the best option for that purpose, though. Some gold investors fail to consider its volatility as well as its opportunity cost, while others fail to anticipate storage needs and other logistical complexities of gold ownership. For these and other reasons, some view U.S. Treasury bills as a superior safe haven alternative to gold. Both asset classes have their own sets of pros and cons; here's a look at them.
- Gold is often hailed as a hedge against inflation - increasing in value as the purchasing power of the dollar declines.
- However, government bonds are more secure and have also been shown to pay higher rates when inflation rises, and Treasury TIPS provide inflation protection built-in.
- Certain ETFs that invest in gold and also hold on to Treasuries may be the ideal solution for most investors.
Slow and Steady vs. Gold Fever
Like any other investment, gold fluctuates in price. Investors may have to wait long stretches to realize profits, and research shows that the majority of investors enter when gold it's near a peak, meaning upside it limited and downside is more likely. Meanwhile, slow but steady Treasuries provide less excitement but reliable income. And the longer the gold is held over Treasuries, the more painful these opportunity costs can become, due to sacrificed compound interest.
An arguably lesser but no-less present worry: some gold investors also must contend with the chore of safely storing their investment, by vaulting it at home or by acquiring a bank safe deposit box. But in either scenario, bullion coins that are held for one year or longer are classified as “collectibles” — similar to artwork, rare stamps or antique furniture. Whether the precious metal is in the form of an American Eagle gold coin, a Canadian Gold Maple Leaf coin or a South African Krugerrand, its sale automatically triggers a long-term federal capital gains tax rate of approximately 28% — nearly double the 15% capital gains rate for typical stocks. (For more, see: Gold is a Great Hedge Today.)
All of that said, gold has fared better than silver, platinum, palladium recently, as well as most other precious metals. After hitting almost $1,900 per ounce in 2011, gold bottomed out at around $1,188 per ounce last December, and in March climbed to over $1,380 per ounce before leveling off at about $1,218 today. Gold's rise this year is at least partially due to the formidable defense gold and silver presents against the eroding value of paper currency. But in light of this trajectory, many believe gold’s future performance is uncertain, and favor a shift to Treasuries.
(For more, see: Curbing the Effects of Inflation.)
The Case for Treasuries
The biggest draw in buying Treasury bonds instead of gold is that the former locks in certain returns on investment. Prescient investors who saw fit to buy $10,000 in 30-year Treasury Bills in 1982, would have pocketed $40,000, when the notes reached maturity with a fixed 10.45% coupon rate. Of course, the days of double-digit percent coupons may be long gone. In January 2014, for example, the U.S. Treasury auctioned another round of 30-year bonds with just a 3% coupon. Nonetheless, such bonds cans still comprise a key element to any risk-averse portfolio. (For more, see: How Safe are U.S. Bonds?)
Still, the government does offer Treasury inflation-protected securities (TIPS), a simple and effective way to eliminate inflation risk while providing a real rate of return guaranteed by the U.S. government. As inflation rises, TIPS adjust in price to maintain its real value. One drawback is that TIPS usually pay lower interest rates than other government or corporate securities, so they are not necessarily optimal for income investors. Their advantage is mainly inflation protection, but if inflation is minimal or nonexistent, their utility decreases. Another risk associated with TIPS is that they can create taxable events when semi-annual coupon interest is paid .
The ETF Option
Depending on your income level, Treasury investments are typically more favorable tax-wise. But gold investors may level the capital gains tax playing field by investing in gold exchange-traded-funds (ETFs), which are taxed exactly like typical stock and bond securities. Within the ETF framework, there are three distinct ways in which investors may participate. The first, gold mining ETFs, benchmark against mining companies, appealing to investors who are not interested in actual commodity ownership. An example of such an ETF is the Market Vectors Gold Miners ETF (GDX).
(For more, see: Top Tips for Day-trading Gold ETFs and Hedge Inflation with Gold ETFs.)
Because these funds hold a combination of contracts and cash — usually parked in Treasury bills — they’re able to generate interest income to offset expenses. An example is AdvisorShares Gartman Gold/British Pound ETF (GGBP). Finally, there are pure-play ETFs, which strive to reflect the performance of gold bullion by directly investing in gold trusts. Bullion bars are purchased, stored in bank vaults and insured. While pure-play ETFs may track the bullion more closely, they have the disadvantage of being taxed more heavily than other versions. An example is PowerShares DB Gold Short ETN (DGZ).
The Bottom Line
Knowing when to bow out of gold can be a tough call. As a hedge against inflation (and geopolitical risk), gold has ascended to great highs over the past decade, due to liberal central bank policies, such as the Federal Reserve’s recent quantitative easing programs. From here, gold could rally or fall further; no one can predict which way it will go. On the other hand, Treasuries take speculation (as well as some excitement) out mix. Savvy investors should take a sober look at gold versus Treasuries in their portfolios and construct an allocation mix that best suits their temperament and time horizon.
(For related reading, see: How to Protect Yourself from Rising Interest Rates.)