Introduction: This article updates my March 14 article titled The Case For Buying Treasuries Now in light of the Cyprus and general eurozone situation, which I believe is bullish for all high-quality US bonds. At the end of this article, I discuss various ETFs that allow a liquid investment in Treasury bonds.
Background: Few stock market investors or income-oriented tax-exempt bond investors focus on price movements of bonds. But bonds move up and down in price, and it is those price movements that result in the yields changing. Even fewer realize that the secular bull market in stocks since their August 1982 low has been weaker than that in bonds.
The S&P 500 bottomed at 102 for the S&P 500 on August 12, 1982. Within a day or days, the Volcker Fed eased monetary policy, and the great bull market for stocks was on. On that day, an investor with $1000 in an IRA could have been the ultimate contrarian and put that money into...a zero coupon 30-year Treasury bond, which was well-known to be a certificate of confiscation, yielding about 13.5%. The S&P has grown 9.2% per year; add in average dividends of about 3% per year (a guess) and one gets 12.2%. But that 12.2% is theoretical, whereas the returns from the Treasury bonds are actual. Mutual funds in the 1980s and much of the 1990s were the only effective way to own "the market," and they had high fees then. So the actual return to a passive indexer to the S&P 500 was likely less than 12% per year.
Furthermore, using that date involves bending over backwards to favor stocks, as by that August, rates had dropped due to the recession. The 30-year Treasury bond market bottomed on Sept. 29, 1981 at 15.20%. The S&P 500 was 116 then. Its total return has only been about 11.5% per year.
Of course, that's ancient history, but we will revisit this topic later and show that not much has changed recently: bonds have mostly still outperformed stocks, even after they plunged in yield in late 2008 and while stocks were still far below their current level.
Ultimately, putting aside ownership of tax-exempt bonds as the mainstay of my permanent portfolio to fund early retirement (hedged with precious metals), I am attracted to Treasuries as trading sardines precisely because they receive no publicity. The media is all about stocks, all the time. Thus I have wondered whether there are better asset classes than what is being pushed onto the public.
What I have found is that whether it was 1987 or 1995, the business cycle was extended several years in association with, and probably because of, a rise in bond prices. Again, most people only think in terms of declining rates, but (to repeat) interest rates are derived, calculated values: they are, in fact, derivatives. The primary asset is the bond. The bond has controlled stocks. When bonds prices have declined, i.e. interest rates have risen, what have we seen? 1987: a crash. 1990: a bear market. Late 1999-2000: a major market peak. 2006-7: the Great Recession.
Because of this, being tactically and/or strategically bullish on bonds does not, not, not mean being bearish on stocks. Here is some thinking on that comparison.
Stocks versus bonds (versus cash): In general, I agree with Jeremy Grantham of GMO regarding relative valuations of different financial assets (free registration required). At the end of February, his previously-on target multi-year (7-years now, previously 10 years) relative valuations shows Treasury bonds (? duration), large cap US stocks, and small cap US stocks all poised to underperform anticipated inflation (2.2% annually). He actually slightly prefers cash to all of these categories. Under this reasoning, continued ownership of bonds is rational; pick your overvalued asset class!
Now to the changes in the world since my last article.
Cyprus and Europe: The plan by the "Troika" to "tax" (confiscate) about 7% of the value of the accounts of all insured depositors in banks operating in Cyprus, even depositors in the sound banks, has sent a chill through savers everywhere in Europe. Happily, that plan was rejected by the Cypriot parliament, but it did come to a vote. Scary indeed.
The result, the requirement that uninsured deposits contribute, as they should under duress, to the resolution of a failing bank, is a serious matter. People are realizing that they should lend money to a borrower who will, first and foremost, give their money back. The idea that a bank deposit, even potentially an insured one, is not money-good is profound. The conservative burghers of Amsterdam and Frankfurt are serious about this, per the Financial Times transcript of its recent interview with the Eurogroup's head. They believe that they finally have a handle on matters and that the proper policy is to protect taxpayers and their government rather than socialize the losses from poorly-made or simply unlucky decisions made by bank managements.
In view of Cyprus and what it has revealed about the thinking of the solvent members of the eurozone, the large liquid government bonds markets should have tailwinds.
Tailwinds are no guarantee of further rate declines, but they help speed one on one's way. And the US interest rate structure is not bad, as things go nowadays.
US rates are reasonable (it's all relative): The US is hardly alone internationally in its ultra-low rate structure. Germany and the UK have similar or lower interest rates all through the yield curve. When and if "push" really comes to "shove," there is only one "fiat currency" that is the ultimate safe haven that can absorb truly large amounts of capital looking for a secure home, even at Japanese-level interest rates (or lower!), and that is the United States. So, however low Germany's rates go, that is at least how low US rates can go if circumstances merit it.
Current US interest rates are toward the high end of the strongest, most efficient and productive internationally-important economies.
Yet, as in 1987 and 1995, rates may "need" to go yet lower for the current business expansion to continue. In the following sections, I use the term "pre-recessionary" to describe a mature business cycle that needs a recharge to accelerate upward and avoid a recession. What more time-tested recharging technique is there than interest rates returning at least to their recent lows? These are about 50 basis points lower than today's levels for both the 10-year T-note and 30-year T-bond.
Pre-recessionary credit market activity - getting frothy again:
Worsening credit standards and increasing defaults are typical signs of a mature/failing business expansion. Unfortunately, this sort of news appears almost daily in the mainstream media now. For example, the GSEs are employing a no-doc mortgage playbook because too many people can't pay their mortgages:
Seriously delinquent borrowers with mortgages owned or backed by Fannie Mae (FNMA) and Freddie Mac will be able to reduce monthly payments without documenting finances under a program introduced by the companies' regulator.
The move announced today by the Federal Housing Finance Agency is designed to stem losses to the U.S.-owned firms by letting borrowers at least 90 days behind on their loans bypass the administrative hurdles of typical loan modifications.
The ongoing student loan programs' very high and rising default rates, and increased lender forbearance of them, also speak to a non-dynamic economy. The high percentage of auto loans that are subprime, discussed in my prior article on Treasuries is in the same vein.
Even Dr. Bernanke is concerned at yet another bubbly activity:
Oh. Only a half-trillion dollar market.
Pre-recessionary Fed Manufacturing Survey trends: Of the five Federal Reserve districts that report monthly on manufacturing within their territories, four of the five look like this from the Fifth District, the Richmond Fed, which reported this week:
These uninspiring results are consistent with the results of this week's Bloomberg Consumer Comfort Survey, which remain close to the recession level of -40. They are also consistent with the diagnosis of Dr. Copper, which has dropped several percent in price since my recent bond-bullish article:
Of course, it may be onward and upward for the economy from here, and if so, perhaps interest rates and stock prices will trend upward for the next thirty years. But if the Reinhart-Rogoff paradigm of a very slow, halting recovery following a major financial crisis continues to play out as it has so far, then several more bond-friendly but economically-challenged years may lie ahead.
Let's look at some technicals.
Technical update: Even as interest rates have begun to drop recently, the Treasury bears in the futures markets continue to bet on higher rates. From FINVIZ:
The speculators' luck may have suddenly changed for the worse, though, as has happened to them repeatedly since 2007; click on "weekly" on the FINVIZ site for a multi-year look at this phenomenon. Just as stocks gapped up on Jan. 2 following the surprisingly amicable and investor-friendly budget decisions late December from Congress, Treasuries gapped up in price (down in yield) on March 18. The speculators are not buying this move, which was related to Cyprus; they may think that Cyprus is a "noise event" to be faded.
At the same time, the chart of interest rates is showing, for the nth time in this ongoing bond bull market, the rate breaking below a horizontal 50-day sma and challenging resistance. The chart for the 10-year bond (TNX) is similar.
Sentiment stinks: The 30+ year long bond bull market is without any doubt the most despised, hated, ignored, and unknown important bull market I have ever heard about in any asset class, much less the one that is arguably the most important one in existence.
Here is about the most bullish commentary I can find in the general blogosphere about the long bond:
Why would anyone would want to add a horrible investment to an otherwise good or great portfolio? No matter. Sentiment on the long T-bond stinks. "Everyone" knows that yields have nowhere to go but up. Speculators have finally unlocked the door containing previously secret instructions about how to strike it rich: buy a diversified large group of small-to-midcap stocks!
Speculators were short and wrong on the Russell 2000 (R2K) the entire bull market until last summer. (Presumably funds hedged by shorting it while going long the specific stocks they owned.) Since last summer, now they have seen that no more such caution is needed. Buy the whole variegated bunch of little guys! Small is beautiful, after all.
We all know that CNBC could never, ever, call the top of a bull market with a headline such as this, could they?
What happened to those AAPL $1000, or better, $1111 predictions, anyway?
Treasuries as capital gains vehicles: The only pure bond is one that compounds its interest payments within the security itself, called a zero coupon bond. In a tax-deferred account, I almost always buy Treasuries as zero-coupon bonds. In addition to having more upside price action if rates fall (and more downside action when rates rise!), they start off with a modest yield advantage over interest-bearing Treasuries. Zeroes are ideal for a self-directed IRA, because there is no pesky reinvestment issue as well as for tax reasons.
Treasuries are all non-callable. It is this feature that allows zero-coupon Treasury bonds to serve as inherently leveraged trading vehicles. Few realize how profound the upside is from owning a zero-coupon Treasury that drops a point in yield.
Recent performance of zeroes versus stocks: Here is a real-world example that puts stocks to shame. We all know that it has been straight up for stocks for about the last year-and-a-half. So let's compare the 2-year performance of the S&P 500 with a generic 30-year T-bond (data as of the close of trading on March 27, 2013).
The S&P 500 has risen 9.2% per year for the last two years, giving about an 11.2% compound annual yield including dividends.
Making a small adjustment for the extra yield a zero-coupon T-bond trades with versus a traditional par bond, I estimate that a 30-year bond purchased by a retail investor 2 years ago would have yielded 4.8%. Today, that same bond would effectively have become a 28-year bond and I estimate it would trade around a 3.15% yield. Using an Internet-based compound interest calculator, that suggests that the price of the bond, which matures at $100, would have been $24.50 two years ago. Today it would be valued at about $42.00. This is a two-year compound average annual return of 31%. Correct. A 4.8% bond has returned about 31% annually, with no risk of capital loss if held to maturity. And nobody talks about it. No one.
Let's go back 3 years. That is almost exactly one year after the cataclysmic bottom of the bear market. Normally the next 3-year period is one in which stocks clobber bonds. Since late March 2010, the annual return from a 30 year zero-coupon T-bond was about 24%. Stocks: 12%. Bonds doubled the return from stocks.
This sort of calculation gets even weirder. Forget 2010. Merely 3 months after the horrible stock market bottom, in the middle of the final month of the recession in mid-June 2009, the S&P 500 was at 921. Assuming a full three years in the calculation of annual return rather than 2 years and 9 months (a limitation of this particular interest calculator), and assuming a 2.5% annual dividend yield, stocks have returned 22% annually. Great!
What have these zeroes returned? Also 22% per year.
A possible conclusion is that the entirety of the stock bull market has been merely an interest rate derivative, except for the surge off the March bottom (which itself was fueled by the greatest bond bull move in memory post-Lehman). This would help to explain why the stock market has outperformed the real economy.
The average annual price change for gold since its 2008 average price around $850/ounce has been about 13.5%. The total return from our 30-year zero-coupon T-bond if purchased 5 years ago is also 13%.
Thus the rise in the price of gold has also been a derivative of interest rate changes.
For both stocks and gold, it is as if there has been some future, expected price. By lowering the discount rate so much because of the bull market in long-term Treasury bond prices, we are fooled into thinking there is an actual bull market in these assets. Right now, these bull markets are looking like illusions. On the actual evidence, there has been no bull market other than the controlling one in bonds. All the price changes from stocks and gold to date have come from lowering the long-term discounting rate.
Let's return to a topic discussed at the start of this article. The long-term stock bull market began in mid-August 1982 when the Fed eased to assist Mexico. Since then, Treasuries have beaten stocks. (In fact, Treasuries have done even better if one simply kept switching from the 30-year bond into a new 30-year bond periodically, such as every 5 or 10 years.)
The conclusion is unmistakable. Not only have total returns from stocks lagged those from bonds at the dawn of the great bull run beginning in August 1982, but even with bonds at average to below average levels both before and shortly after the Great Recession, bonds have been the superior financial instrument.
This does not mean that anything like the above returns will occur again; they cannot. But recent financial market action is consistent with the action seen in other mature economic expansions. It has been 63 months since a mild recession began in December 2007. In the past 95 years, since hostilities in WW I ended and the Fed began functioning in peacetime, there have been 17 recessions- one every 67 months.
How to buy Treasuries: Investors with a longer-term time frame who are willing to hold a bond to maturity, even if it is a 20-30 year maturity date, are usually best off purchasing the bond directly. If it is a zero-coupon Treasury, taxes are levied on the implied yield each year. Thus if such a bond is held in a taxable account, the holder pays a form of phantom tax, as the bond throws off no current income. I purchase and own such bonds in a self-directed IRA.
Traders who want maximum liquidity in trading the long bond, as well as investors who want a monthly payout, often purchase the iShares 20+ Year Treasury Bond ETF (TLT). This ETF currently owns ultra-long duration interest-bearing T-bonds.
Investors who want a pure speculation on interest rates can purchase the PIMCO 25+ Year Zero Coupon U.S. Treasury Index Exchange Traded Fund (ZROZ). This accrues the value of these very long-term zero coupon bonds within the fund. It is very volatile and trading volume can be scanty. Somewhat less volatile than ZROZ is the Vanguard Extended Duration Treasury Index ETF (EDV), which owns zeroes but makes periodic payments to shareholders.
ZROZ and EDV are highly risky, since unlike an individual bond that can be held to maturity, they never mature. TLT has similar though more limited risk should interest rates trend up for decades.
There are of course numerous other ETFs with different maturities, as well as many mutual funds that allow ownership of Treasury bonds.
Conclusion: If you agree with me that US stocks are reasonably valued because interest rates on bonds are so low, then you may wish to have exposure to Treasury bonds. A liquid way to own traditional Treasury bonds and receive a monthly payout is via TLT. The post-Cyprus realization, at least within many countries in Europe, that one's principal is no longer completely safe in a bank account may lead to greater interest in direct ownership of government bonds to secure the combination of increased safety of principal with a guaranteed positive yield. The US economic expansion is mature and approximately as old as the average expansion in the era of the Federal Reserve.
Thus, Mr. Bond may once again be called upon to save the day.
Additional disclosure: I am not an investment adviser. Nothing herein constitutes investment or trading advice.