TLT: Why This Long-Term Treasury Bond ETF May Be A Good Portfolio Diversifier

Feb.12.13 | About: iShares 20+ (TLT)

Just because a mainstream asset is widely despised does not mean that it's a good investment choice-- but it helps. It helps even more if Ben Bernanke is on your side.

This article makes the case that stock-oriented investors may wish to consider gaining exposure to Treasury bonds in their portfolios.

United States Treasury bonds, notes and bills (collectively, bonds) underpin the world's financial system, given that the U.S. dollar is the major reserve currency of the world. There are many considerations other than inflation rates involved in countries, corporations and financial institutions holding Treasuries. Treasuries can move in sympathy with other bonds, or differently. Since the early 1980s, both stocks and long-duration Treasury bonds have had similar total returns. The Treasury bull market has helped the stock bull market along. There is no easy way to predict which asset class will be superior over the next few years. There is also no way to predict with any certainty how an aging U.S. investor base will assess the importance of the return of capital promised by bonds with the potential appreciation of capital (widely perceived to be uncertain) plus dividends promised by stocks.

The Fed is buying Treasury bonds (also called T-bonds), and the Fed is the ultimate deep-pocketed investor that never has to sell. Its zero interest rate program (ZIRP) will continue until it stops, and even the Fed does not know when that will be. Thus, calling the end of the move down in interest rates is guesswork.

The most liquid way to gain stock market exposure to the long-term Treasury bond is via the iShares 20+ Year Treasury Bond ETF (NYSEARCA:TLT). Assets under management are over $2 B, and the average maturity in TLT is 28 years. The average duration is 17 years, which is less than that of the stock market as a whole. Management fees are 0.15% annually. Current yield of the portfolio is around 3%.

Very aggressive ways to purchase Treasuries are with zero-coupon bond funds, namely PIMCO 25+ Year Zero Coupon U.S. Treasury Index Exchange-Traded Fund (NYSEARCA:ZROZ) and Vanguard Extended Duration Treasury ETF (NYSEARCA:EDV).

What follows are important points in the contrarian argument that Treasuries are interesting investments for many of us.

Fundamental considerations:

1. The Fed and the other major banks in the G-7 began purchasing government bonds (quantitative easing, or "QE") after the financial crisis hit in 2008 because the major financial institutions had gone bankrupt, or would have absent QE (along with other emergency measures, to be sure). The newly-created money (bank reserves, technically) that the central banks "printed" out of thin air has been necessary to save the banks. When the Fed believes the banks are truly solvent and the economy is in a self-sustaining expansion, QE may well cease. When will that be? No one knows, not even Chairman Bernanke.

The Fed's current zero interest rate policy (ZIRP) could last many years-- or it could end soon. The effects on T-bond rates will be significant.

The Fed began "QE 2" in 2010 and then "QE 3" in 2012 because it was convinced that the financial system required more capital to allow debts to be repaid, home prices to reverse their deflationary path, and for the economic expansion to continue.

The Fed has been pursuing an anti-deflationary or mildly inflationary path, at least in its eyes. If this is a correct view, then just as in Japan, interest rates may drop with little warning if deflationary threats reappear. TLT would rise in price in that case.

2. This has been the most fragile business expansion at least since 1960 (and see page from which this has been copied for more detail):

Recession probability
Never before, going back at least until 1960, has a business expansion been interrupted by real-time evidence that a greater than 10% chance that the economy is back in recession. This has now happened twice, in 2011 and again last year. Every other time, as in 1979 and 1989, a recession was beginning. (The exception was after Hurricane Katrina in 2005. This was a special case in that the disaster briefly affected the national macroeconomic data.)

The Chicago Fed's National Activity Index shows this to be the weakest business expansion in decades, and also shows that the vigor of each successive economic expansion has been weakening for decades (see link for the Fed's commentary):

Click to enlarge

A weak, fragile low-inflation expansion is prone to deflation if left to its own devices. The Fed repeatedly complains that inflation is below its 2% goal.

3. Evidence that the Fed's activities have been supportive rather than incendiary also come from the Chicago Fed's inflation data, shown via the link above in the final chart. This can be also seen via MIT's Billion Prices Project, which demonstrates about two months of deflation at the end of last year within its segments of the economy that it monitors.

4. Click to view two graphs showing the Japanese interest rate experience following the bursting of their twin real estate and stock market bubbles, which began in 1989. Japan had been used to rapid growth and high interest rates. The Japanese had no reason to expect what was to come. Their current interest rate structure was a surprise to them. Might we look back in 2020 and be similarly surprised?

Japan went to near-ZIRP in 1995 and to ZIRP four years later. The Fed went to near-ZIRP in 2003 when it lowered policy rates to 1%, and then to ZIRP in 2008, following Lehman's collapse. Thus there are parallels between the interest rate structure of the two countries despite the obvious differences.

As Japan's economy has waxed and waned since 1999, interest rates of progressively longer duration began dropping closer to the zero bound. Similar trends have been present in the U.S. since ZIRP began. Even though the prime minister of Japan, Mr. Abe, is threatening to implement policies designed to bring inflation up to 2%, their 10-year bond remains mired at 0.80% or less. Their 30-year bond trades around 2.0%. Low interest rates can be very sticky.

Persistent low and dropping interest rates are consistent both with a strong Japanese economy as well as recession (interest rates plunged in 2003):

Japan's recovery from 2002-2008 was the longest unbroken recovery of Japan's postwar history, and was in fact stronger than the growth of other comparable economies.

This might be the case in the U.S. going forward, as well. Rates have trended down since mid-2009 as the recession ended and recovery began. Non-inflationary prosperity could be around the corner, (we can hope) which would be friendly to all bonds.

5. American savers and investors are being starved of yield in all investment categories, not only bonds and CDs. Stock market dividend yields are at least as low relative to historical norms as are bond yields.

This chart shows the S&P 500 dividend yield going back to 1870, followed by the 10-year T-note's yield.

S&P 500 Dividend Yield Chart

Current Yield: 2.06% -1.16 bps

4:35 pm EST, Fri Feb 8
Mean: 4.44%  
Median: 4.38%  
Min: 1.11% (Aug 2000)
Max: 13.84% (Jun 1932)
Click to enlarge

Compare this to historical 10-year Treasury yields:

10 Year Treasury Rate Chart

Current 10 Year Treasury Rate: 1.99% +0.00 bps

At market close Fri Feb 8, 2013
Mean: 4.65%  
Median: 3.92%  
Min: 1.53% (Jul 2012)
Max: 15.32% (Sep 1981)
Click to enlarge

Using the criterion of cash payments to investors, there is no clear reason to choose between stocks and Treasuries. One can find a stock index with a yield that matches yields of Treasuries, depending on the duration of the T-bond.

A look forward 8 years shows how easy it will be to lose money in the stock market even if dividends increase at, say 6% yearly. The current yield on the '500' is reported as 2.06%. After 8 years, if the index price is the same, the yield would then be 3.28%. That would imply that after 8 years, and investor in the SPDR® S&P 500® ETF (NYSEARCA:SPY) would give the investor aggregate dividends of about $20 for every $100 invested: a gross 20% return. However, if the market merely required the historical median (and average) dividend yield of 4.4%, the investor would suffer about a 25% loss of principal. Netting dividends against capital loss suggests about a 5% negative total return.

This investor would have been better off in cash, or an 8-year Treasury.

Stocks are therefore not safe; neither are long-term bonds.

One can ask what investment alternative there is to stocks, given how low bond rates are (and with cash yielding close to zero). The question can also be turned around. How many income-oriented investors will look at the low dividend yields available from the SPY and prefer to accumulate cash or invest in short-to-intermediate term bond vehicles while waiting for rates to rise? Investor preference for capital preservation over asset appreciation would tend to help the long bond's yield.

6. The U.S. fertility rate has reached perhaps an all-time low of 2.06 children per woman, which would imply zero population growth level except for the trend of the elderly living longer. The low fertility rate implies less future inflationary strain on resources and is consistent with persistent slow economic growth.

7. The most comprehensive measure of unemployment, U-6, has stabilized at extraordinarily high levels, around 14.4%. Unless this statistic resumes a strong and much-welcomed downtrend, this much slack in the labor market could allow for a prolonged period of low inflation, which would be bullish for bonds and TLT.

8. A recession is possible even with ZIRP or near-ZIRP. Japan's example shows that to be true. A recession could drive Treasury yields much lower.

9. The robotic revolution and other productivity enhancements may allow for "good deflation" to take hold, to our overall betterment. Such a situation would be intrinsically anti-inflationary.

10. As Doug Short demonstrates:

Essentially we are in "uncharted" territory. Never in history have we had 20+ P/E10 ratios with inflation in the low 2% and lower range. The closest we ever came to this in US history was a seven-month period from October 1936 to April 1937. During that timeframe the 10-year yield averaged 2.67%, about 60 basis points above where we are now. How did the market fare? The S&P Composite hit an interim high (based on monthly averages of daily closes) in February 1937. The index plunged 44.9% over the next 15 months.

Technical considerations:

TLT might be approaching a potential trading "buy" point.

1. The Investor's Intelligence Bullish Percentage has risen to 73.4% from as low as 20% at the stock market bottom after the sharp summer downturn that year. Comparing that chart to that of TLT shows that when the Bullish Percentage has been in the current range, especially if sustained for a couple of months or more, TLT has then tended to rise.

2. Sy Harding's blog has a recent post showing that as of Feb. 1, his measure of the T-bond on the futures market had dropped to oversold levels. Since 2009, this reading has tended to mark bottoms for TLT's price (relative peaks in interest rates).

3. The futures market for the 30-year bond now shows enough speculator negativity to support a rally, either a reflex rally or something more major (click through to Finviz for better detail and to change the time frame):

Speculators were optimistic about the long bond last summer when yields were low and the price of TLT was high. They are now pessimistic when yields are higher. (When the green line is much above zero, as it is now, that means that speculators are short the futures and the commercial interests are long; vice versa when the green line is below zero.)

The above points suggest that the markets may be primed for a tradeable move in TLT from the long side should some unanticipated negative newsflow discourage economic optimists. TLT will tend to rise when and if stocks decline.

Summary of the above: The Fed has been buying bonds only because the financial system nearly collapsed in 2008, and not because Ben Bernanke is a rampant inflationist. It can be argued that the system had so much leverage that trillions of dollars needed to be inserted by the Fed to prevent a ruinous deflation. The very high current U-6, and other data, provide no reason to be confident that the Fed's ZIRP policy is about to end. It might end soon, or it might go on for many years as in Japan: we just do not know. If it is persistent, long-term T-bonds may trend irregularly lower in yield, as in Japan.

TLT provides a secure positive yield, though because it is a fund, it never has to return to par, as direct ownership of a U.S. Treasury bond should guarantees. TLT can function as a portfolio diversifier that tends to move in the opposite direction from stock prices. It could actually appreciate in value, as well, as it will do if long T-bond market yields drop.

From a timing perspective, stocks have had a long, strong surge since the 2011 market bottom. Bonds have suffered a sell-off. A reversal could be in the offing.

Risks: There are numerous, meaningful risks to an investment in TLT, or any long-term bond or bond fund. There is the risk of capital loss due to rising interest rates. High inflation could return and would erode the value of TLT's modest interest rate payments, even if the Fed prevents interest rates from rising. Another type of risk is that TLT could turn out to be a mediocre investment, but that stocks as a whole, and/or commodities, could be much better investments: thus a meaningful opportunity to earn substantial profits could be lost.

The above list of risks is far from comprehensive.

Final comments: Given how abnormal the financial landscape is today, investors may wish to recall this adage:

Don't fight the Fed.

The Fed is buying and holding Treasury bonds. No financial institution has as deep pockets or as good information as the Fed. It never has to sell. It does not like to lose money.

On the other hand, the Fed is a non-economic purchaser of these bonds. Its interests involve public policy; investors want the right risk-reward. Investors should not blindly do what the Fed does.

All in all, the parallels with Japan and the other points made herein suggest to me that makes sense for many stock market participants to consider gaining some exposure to TLT or a different Treasury bond fund, or even direct ownership of Treasury bonds themselves.

Disclosure: I am long TLT, EDV. 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.