With Treasuries, It's Not About The Interest Rate

| About: iShares 20+ (TLT)

It seems any time the topic of Long Dated Treasuries (NYSEARCA:TLT) is written about, I notice many people have a true hate for them as potentially the worst investment you can make. The majority seem convinced that anyone wanting to own the long bond is foolish. Without fail, everyone seems to know the reasons why as well. I probably don't have to tell you their points as they are so prevalent, but here are just a few in case you have recently awakened from a coma:

- Bond prices are in a "bubble"

-Inflation is higher than the interest rate

-The US Government is bankrupt. Who would lend money to them for 30 years.

-Rates are at generational lows, they can only go up from here (meaning bond prices will fall)

-Why would you want to tie your money up at 3% for 30 years?

(Feel free to post other common reasons to hate Treasuries below)

In a recent article here on Seeking alpha, the common causes for disdain of Treasuries were on parade in the comment section:

"The time is nigh when a good short long treasuries ETF is to be bought. Not only can treasuries not get much higher and the yields much lower, but inflation will kill the real value anyway, even if the nominal price holds."

"The case for buying treasuries was back in early 1980's, NOT now."

"Maybe a one to two year trade long in bonds makes sense, but sooner or later, I think we'll enter a long-term bond bear market."

"I believe it is the worst time to buy treasuries."

From today's Wall Street Breakfast: "On year, inflation is seen increasing to 1.9% from 1.6%." If you buy 10 year Treasuries paying 2% fully taxed and inflation stays at only 1.9% throughout that time (with printing presses running, highly unlikely) your money is losing in purchasing power."

"It's a risky gambit, and either way it bodes ill for bonds, with either rampant inflation eroding the value of the bonds or them being supported by an ever shakier government balance sheet."

"...I don't see why you'd want to own treasuries unless you're expecting decades long deflation like Japan..."

There are many more, but I think you get the point.

Even the smart money has a disdain for Treasurys. Warren Buffett is on record for saying that bonds should come with a warning label. Leon Cooperman, CEO of Omega Advisors, stated "bonds will be the worst place for investors to put their money for the next 3 years" and "U.S. Treasuries are the least attractive investment in a world of financial repression." The bottom line - it truly is not a hard task to find reasons why the herd hates the Treasury market.

While most of the reasons seem sound, logical and potentially sprinkled with some truth, the argument against them is NOT the reason you should consider owning them. Lending the U.S. Government money for 30 years at 3% versus the inflation rate should not be the determining factor for an investor to buy them.

The main reason you should consider buying long dated Treasuries: they are the only investment that pays you to hedge your stock portfolio.

There are many options to hedge long exposure to the stock market. In the past I have bought inverse index ETFs (NYSEARCA:SH) against a portfolio of individual stocks in order to reduce my volatility. This has proven time and again to be a VERY expensive hedge. The other option many investors have an appetite for are put options. I read all the time about investors who get worried deciding to buy S&P 500 (NYSEARCA:SPY) put options when they feel the market is about to correct. Take a look at the prices of long dated put options though:

SPY Current Price: $155.21

Dec 19, 2015 Expiration

150.00 Put Bid 17.32


155.00 Put 21.71 22.00
155.00 Put 19.81 24.03
160.00 Put 24.30 24.89
160.00 Put 22.47 26.71
161.00 Put 24.86 25.46
Click to enlarge

As you can see, in order to buy stock market protection for the next 33 months, it will cost you 14% (155 Put costs $2200 in premium to protect $15,521 in S&P 500 long exposure).

Assuming that stocks go nowhere for the next 33 months, your protection will cost you .42% per month, or about 5% per year. If you are a dividend investor that uses the income from your investments to pay your bills, that cost is a huge anchor to your lifestyle. Looking at this cost, one wonders why the smart money is not claiming that put options are a hazard to your wealth.

In order to explain the benefit of long dated Treasuries as the best hedge against volatility in a stock portfolio, I will show you a few pictures, as they are worth a thousand words:

This chart shows the price of an ETF portfolio of long dated Treasuries vs. the price of the ETF that represents the S&P 500 during trading on March 25, 2013. While not a 1 to direct inverse correlation, you can see that price action is nearly a mirror image of each other. The anti-correlation between the Barclays Long U.S. Treasury Index and the S&P 500 index remains quite strong at -.7 as per SoberLook:

Now let's take a look at the previous two years of price action:

What you will notice is the same near mirror-image performance. Now the price of put option protection 2 years ago would have been much higher than it is today due to the fact the VIX was much higher then compared to today. I don't have the numbers, but I would guess that buying 33 months of downside protection would have cost an investor much more than 5% per year. The chart above shows that owning long dated Treasuries would have been a much more profitable option as TLT not only gained in share price, but more importantly, the hedge PAID investors 3-5% during this time. Imagine that! A near hedge against a stock portfolio that pays you to protect yourself.

Now that you can see owning Treasuries as a hedge against volatility in a stock portfolio might help you sleep better at night, there is a better way to hedge your stocks than just owning an ETF. TLT is required by mandate to only hold Treasury bonds that mature in 25+ years. If rates do end up going steadily higher, the bonds held by the ETF will go down in value, and until rates drop again, you may never recover lost principal during your life time. Rather than buying an ETF, I would suggest buying the individual bonds and holding them to maturity. One way to do this is to buy a long dated Zero Coupon Bond. Zero coupon bonds are bonds that do not pay interest during the life of the bonds. Instead, investors buy zero coupon bonds at a deep discount from their face value, which is the amount a bond will be worth when it "matures" or comes due. When a zero coupon bond matures, the investor will receive one lump sum equal to the initial investment plus the imputed interest.

Today, you can buy a US Treasury Zero Coupon Bond maturing November 11, 2041 for $38.85. This means that on the maturity date, your bond will be worth $100, guaranteed by the U.S. Government. The current yield to maturity is 3.329%. So an investor with $1 million who wants to reduce their current portfolio volatility while getting paid for the privilege could invest $388,500 in this long dated Zero Coupon Treasury, and invest the remaining $611,500 in dividend paying stocks. In a worst case scenario, let's assume every single stock you buy goes to $0. In 2041, your portfolio will be worth $1 million because the value of your Zero Coupon Bond will have appreciated to that amount. It's almost like having a principal guarantee for your portfolio if you hold the Zero to maturity. In 28.5 years, you are certain to make $611,500 on your Zero Coupon Bond. Keep in mind this does not factor in inflation which will erode the real value of the $1 million, but the point is you reduce the risk of complete loss. If held to maturity, the Zero Coupon will AVERAGE $21,456 in gains per year. Keep in mind this is not a static number. In years when interest rates rise or stocks are strong, you might see the value of the Zero go down for the year. An investor should not sell or become disheartened though. Due to the nature of the bond, any money "lost" will be made up in future years, guaranteed by the full faith and credit of the U.S. Government. Remember, held to maturity, you will receive a price of $100 per bond that you can buy today for $38.85 ($388.50 per $1000).

With the long term risk of portfolio value impairment reduced, along with the psychological hurdle of portfolio volatility in the short term mitigated, take a look at the options one might have for income with a portfolio of income stocks.

Investment/Amount/Yield /Avg Income Per Year

(NYSEARCA:AMLP) $101,916/5.94/$6054

(NYSEARCA:IYR) $101,916/3.52/$3587

(NYSEARCA:REM) $101,916/11.31/$11526

(NYSEARCA:XLP) $101,916/2.80/$2853

(NYSEARCA:XLU) $101,916/3.86/$3934

(NYSEARCA:PFF) $101,916/5.97/$6084

While I do not recommend this as an actual portfolio, it resembles a portfolio of diversified stocks that pay large amounts of income to an investor. The portfolio is evenly balanced between a basket of MLPs, REITS, Mortgage REITS, Consumer Staples, Utilities, and Preffered Stocks. I would argue this portfolio leans towards being very conservative as most of these investment categories are considered defensive investments. The income alone from the stock portion of this portfolio is $34,038 per year. On a $1 million portfolio, that alone is a 3.4% yield, which is by itself much higher than you can get from the stock market alone, let alone banks and CDs. It is about the same yield of an all Long Bond portfolio, yet you own stocks that can grow not only in price, but their dividends can keep up with inflation. When you factor in the average $21,000+ per year growth in value (only if held to maturity) in the Zero Coupon Bond, and you are looking at dividends plus deferred interest of over $55,000 per year on average. That is over 5.5% per year, in a portfolio that is well balanced with 61% being somewhat offset by the other 39% in terms of price action.

SoberLook.com also states that long term Treasuries have provided the largest reduction in portfolio volatility while allowing the investor to maintain a fairly high exposure to equities:

Click to enlarge

As you can see, owning Treasuries is not just about the interest rate. Avoiding them solely on the basis they are not paying enough for the next 30 years based on their current low interest rates is missing their true benefit to a portfolio. The main reason you should consider buying them today is they are the only investment that will pay you for the next 25+ years to reduce the volatility in your overall portfolio value. Everything else is just a sideshow.

Disclosure: I am long AMLP, XLP. 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.

Additional disclosure: I or my clients are long individual stocks that make up the underlying ETFs mentioned in the hypothetical portfolio of this article. We also buy or are in the process of buying invdividual Zero Coupon bonds for select clients that want volatility reduced in their portfolio, although not all clients own them.