Why Long-term Government Bonds Are The 'Dumbest Investment'

by: Robert Wagner

DunceIn this video, long-term government bonds are called the "dumbest investment" for the current market environment. This may come as a surprise to many people who believe government bonds are risk free and guarantee the holder against loss. This is true only if the owner holds the bond to maturity, and even then, it only guarantees a positive nominal return, not a positive real return. Low-yielding long-term bonds provide little protection against inflation if it develops in the future. Mutual funds on the other hand, even ones that hold 100% government bonds, offer no such guarantees. Most bond mutual funds never mature (I'll explain the "most" later), have an internal expense ratio and because of constant turnover within the portfolio that may prevent bonds from being held to maturity, an investor may never get his or her initial investment back.

Why then are long-term government bonds the "dumbest" investment? The reason for this is obvious; interest rates are at or near record lows, not just for treasuries, but many corporate rates as well. Bond prices and interest rates are inversely related. As interest rates fall, bond prices increase. With interest rates near or at record lows, with little room to fall further, bonds mathematically are near a peak. Unlike equities, bonds have a theoretical peak value when interest rates reach 0% interest. In the real world, 0% in the bond world should be the rate of inflation. Every textbook I ever read explains that a bond's interest rate is comprised of a nominal rate consisting of a real risk-free rate and premiums to compensate for default, liquidity and maturity, and an inflation premium to compensate for inflation. I was always taught that an interest rate below the rate of inflation made no sense, and that it could not exist in the markets, at least not for long.

Well, throw out the text books, that condition exists right now. Currently the yield on the 10-year U.S. Treasury bond is 1.94%, and the latest CPI shows inflation increasing at an annual rate of 2.00%. Sure this may be a short-term anomaly, but one thing is for sure, interest rates are very close to what traditionally has been consider 0%, that being the rate of inflation. This following quote is from an article where someone asks about the current environment where interest rates are below the rate of inflation. I find the explanation of the safe haven plausible, and would expect fear to be short term.

I do not understand how interest rates could be less than inflation. Historically, 90 day tbills track inflation plus a small premium. Now with inflation at let's say 4% or so, how can everything shorter than 30 years be BELOW the inflation rate…way way below!

If rates don't have any further to fall, then the only remaining direction is up, and it is that fact that supports comments about long-term government bonds being a "dumb" investment. If interest rates can only go up, bond prices can only go down. Bonds have effectively shaved off the right side of their return distribution. You can either hold the bond to maturity and make a 0% real return on the interest, or you can lose money on the principle when the rates increase. There is no way to make a real return given the current market environment if in fact we are at the bottom of the interest rate cycle. Yes, if we fall into a deflationary period and rates do fall further this theory of long-term government bonds being a "dumb" investment will be proven wrong, but given the current monetary policy of QE until the cows come home, I don't consider that a likely outcome. This video titled "Fed's Unwinding Could Be a Problem" highlights how the problem the Fed faces isn't from stopping rates from going lower, but from stopping them from increasing too fast once the Fed decides to shift policy. The fear is that it could trigger a rush for the door as traders rush to lock in profits before the rates increase too much, therefore becoming a self fulfilling prophecy of rapidly increasing interest rates being fed by panic selling. It is almost like a giant game of musical chairs where everyone knows the music will stop some time, they just don't know when, but once the music does stop, there is a mad, irrational, emotion driven dash for the remaining chair.

The metric used to explain how much a bond price will change with a change in interest rates is "duration." If a bond has a duration of 30, and interest rates increase by 1%, the bond price falls by 30%. Typically the longer the maturity, the longer the duration of a bond, and that is why buying long-term government bonds is "dumb." With interest rates having basically nowhere to go but up, long-term government bonds basically have nowhere to go but down, and if they have long durations, the losses can be substantial.

Here is a list of the 7 largest bond ETFs, their assets and duration:

  1. Barclays TIPS Bond Fund (NYSEARCA:TIP) - AUM - $20 Billion - Duration - 8.23
  2. iBoxx $ Investment Grade Corporate Bond (NYSEARCA:LQD) - AUM - $24 Billion - Duration - 7.76
  3. Total Bond Market ETF (NYSEARCA:BND) - AUM - $117 Billion - Duration - 5.3
  4. Barclays Aggregate Bond (NYSEARCA:AGG) - AUM - $15 Billion - Duration - 4.75
  5. iBoxx $ High Yield Corporate Bond Fund (NYSEARCA:HYG) - AUM - $15 Billion - Duration - 3.89
  6. SPDR Barclays Capital High Yield Bond ETF (NYSEARCA:JNK) - AUM - $12 Billion - Duration - 4.18
  7. Barclays 1-3 Year Treasury Bond (NYSEARCA:SHY) - AUM - $7 Billion - Duration - 1.81

I mentioned above that I would explain the "most" from this quote:

Most bond mutual funds never mature (I'll explain the "most" later)

Guggenheim has a family of what it calls "Bullet Shares" that are mutual funds, exchange traded mutual funds, that actually do mature, and are designed to behave more like owning an actual bond. This eliminates a few of the problems normal open ended bond mutual funds face such as a meaningful yield to maturity and a final maturity date.

  1. Guggenheim BulletShares 2013 High Yield Corporate Bond ETF (NYSEARCA:BSJD) - AUM - $200 Million - Duration - 0.93
  2. Guggenheim BulletShares 2014 High Yield Corporate Bond ETF (NYSEARCA:BSJE) - AUM - $266 Million - Duration - 1.79
  3. Guggenheim BulletShares 2015 High Yield Corporate Bond ETF (NYSEARCA:BSJF) - AUM - $337 Million - Duration - 2.48
  4. Guggenheim BulletShares 2016 High Yield Corporate Bond ETF (NYSEARCA:BSJG) - AUM - $109 Million - Duration - 2.69
  5. Guggenheim BulletShares 2017 High Yield Corporate Bond ETF (NYSEARCA:BSJH) - AUM - $51 Million - Duration - 3.17
  6. Guggenheim BulletShares 2018 High Yield Corporate Bond ETF (NYSEARCA:BSJI) - AUM - $45 Million - Duration - 3.36
  7. Guggenheim BulletShares 2013 Corporate Bond ETF (NYSEARCA:BSCD) - AUM - $172 Million - Duration - 0.46
  8. Guggenheim BulletShares 2014 Corporate Bond ETF (NYSEARCA:BSCE) - AUM - $236 Million - Duration - 1.36
  9. Guggenheim BulletShares 2015 Corporate Bond ETF (NYSEARCA:BSCF) - AUM - $200 Million - Duration - 2.3
  10. Guggenheim BulletShares 2016 Corporate Bond ETF (NYSEARCA:BSCG) - AUM - $194 Million - Duration - 3.16
  11. Guggenheim BulletShares 2017 Corporate Bond ETF (NYSEARCA:BSCH) - AUM - $233 Million - Duration - 4.03
  12. Guggenheim BulletShares 2018 Corporate Bond ETF (NYSEARCA:BSCI) - AUM - $60 Million - Duration - 4.55
  13. Guggenheim BulletShares 2019 Corporate Bond ETF (NYSEARCA:BSCJ) - AUM - $47 Million - Duration - 5.25
  14. Guggenheim BulletShares 2020 Corporate Bond ETF (NYSEARCA:BSCK) - AUM - $25 Million - Duration - 6.21

In conclusion, if you own any of the above bond funds, or a bond fund in general, it is important that you are aware of the duration of the portfolio. In a rising rate environment a shorter duration is better than a longer duration. It is also important to understand that you can lose money if you sell a government bond before maturity or own a government bond mutual fund during a period of rising rates. In my next article on this issue I will address alternatives to holding government bonds in your portfolio.

Disclaimer: Opinions expressed herein by the author are not an investment recommendation and are not meant to be relied upon in investment decisions. The author is not acting in an investment advisor capacity. This is not an investment research report. The author's opinions expressed herein address only select aspects of potential investment in securities of the companies mentioned and cannot be a substitute for comprehensive investment analysis. Any analysis presented herein is illustrative in nature, limited in scope, based on an incomplete set of information, and has limitations to its accuracy. The author recommends that potential and existing investors conduct thorough investment research of their own, including detailed review of the companies' SEC filings, and consult a qualified investment advisor. The information upon which this material is based was obtained from sources believed to be reliable, but has not been independently verified. Therefore, the author cannot guarantee its accuracy. Any opinions or estimates constitute the author's best judgment as of the date of publication, and are subject to change without notice.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.

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