How Risky Are Bonds? Stocks?

Includes: SPY
by: Ploutos

My wife, a pediatric nurse practitioner, finds herself in a lot of conversations about finance. The financial markets are both my chosen profession, and writing about them on Seeking Alpha, one of my chosen hobbies. She graciously lets the dinner conversations veer towards my interests too often. Recently, on a trip to see family over the holidays, I asked: "What are the two most important concepts to consider on a given investment?" She answered without much hesitation: "Risk and return." She never ceases to amaze.

When I queried her on these concepts, I was mentally building the framework for this article. For a given expected return, we must assume a certain amount of risk, or the variability around our expected return the outcome over a given time interval will fall. In modern finance, the hypothetical "risk-free" rate has always been assumed to be U.S. Treasuries. Backed by the full faith, credit, and taxing power of the largest economy in the world, and denominated in the world's reserve currency, Treasuries were assumed to be the closest proxy for a hypothetical risk-free investment. During the credit crisis and subsequent Great Recession, Treasuries rallied in part as a safe haven investment despite mounting fiscal deficits. Of course, we know that U.S. Treasuries are not actually risk-free. The debt ceiling drama of July-August 2011, and subsequent U.S. downgrade certainly reinforced that notion despite the fact that the turmoil only caused Treasuries to rally more.

As interest rates have fallen on U.S. Treasury securities, the duration of these securities has extended. Duration has a dual meaning in finance. It is both the weighted average timing of cash flows, the periods at which bonds pay their promised principal and interest, and also a measure of interest rate sensitivity. A thirty-year U.S. Treasury with a pre-crisis yield of 5.5% had a duration of roughly 15. With the yields of thirty-year Treasury bonds hovering around 3% today, the securities have a duration of almost 20. From the first definition of duration it is easy to understand why there is a difference. The lower coupon causes investors to get their promised cash flows back later on average. Holding a thirty year bond to maturity, absent default, your average annual return will be the current yield to maturity. Returns may vary from year-to-year because of changes in interest rates, but will average the current yield until maturity. Today, investors in thirty year Treasuries have an expected return of just over 3%, but their year-to-year variability of return has increased by one-third given the duration extension. Expected return is lower and risk is higher, my wife, the nurse, understands that this is a bad tradeoff.

How bad is this tradeoff? How risky are thirty-year Treasuries today? Let's examine the trailing volatility of thirty-year bonds versus the S&P 500 (NYSEARCA:SPY). Below is a graph of the annualized standard deviation of daily price moves of the S&P 500 and the thirty-year Treasury.

Source: Barclays Long Treasury Index, Standard and Poor's

For you stat heads, what is graphed above is actually a time series of the standard deviation of the price change of the last 252 trading days (one year) annualized (multiplied by the square root of 252).

It does not take advanced degrees in statistics to understand that risk, the variability of returns, has been rising in fixed income as durations have extended, and falling recently in the equity markets. The annualized standard deviation of daily price changes of thirty-year bonds and the S&P 500 are now both around 12%. While this is a look at trailing volatility, it should be noted that implied, forward-looking volatility, as represented by the VIX began trading with a 12-handle for the first time in five years just last week. We know that the expected return of owning a thirty-year Treasury until maturity is 3%. I believe that the expected average annual nominal return of owning U.S. equities is much higher. Historically, it has been more than 3x higher than the current expected return on Treasuries.

This has important implications beyond just the Treasury market. Credit spreads on long duration high quality fixed income - investment grade corporate bonds and municipals - have seen their credit spreads collapse post-crisis. Absent further material credit spread tightening, these securities' risk profile will look a lot like the Treasury bond graphed above.

While Treasury bonds will seemingly continue to offer a negatively correlated holding to other risky assets in your portfolio, investors who have materially overweight fixed income over the last five years should begin the rotation to equities. The risk/reward is skewed negatively against continuing to hold long duration fixed income. In past articles, I have highlighted the benefit of owning low volatility equities and dividend paying equities. These classes of securities will have lower volatility than the broader equity market, and have actually outperformed the S&P 500 over the trailing twenty years. I believe these securities will also have lower volatility over the intermediate term than long duration fixed income securities, and could serve as a good bridge for investors looking to rotate from fixed income into asset classes with a higher expected return.

Disclosure: I am long SPY. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.