If you’re someone who regards the enormous growth in money supply and expansion of the Fed’s balance sheet over the past two years as highly inflationary, you probably expect that today’s low Treasury bond yields don’t remotely compensate for these risks down the road. If you look at the sorry state of Federal and state budgets and ask yourself how governments can borrow so cheaply, you’d be similarly wary of locking in, say, an interest rate of 2.80% for ten years.
For my part, Treasury yields usually appear either low, too low or ridiculously low and in recent years I’ve had to recalibrate the returns I’d like with what’s generally been available.
An article in the Financial Analysts Journal (Explaining and Forecasting Bond Risk Premiums by Gerardo Palazzo, CFA and Stefano Nobili) adds an interesting perspective to the question of why Treasury securities never seem like a bargain. The FAJ publishes academic articles with a heavy dose of Math, as befits a division of the CFA Institute. The authors use the Capital Asset Pricing Model (CAPM) to calculate what the risk premium on Treasury bonds should be. CAPM is a framework for valuing assets (including but not limited to equity securities).
Let me try and put it in layman’s terms for those who don’t spend their time wading through these kinds of papers, because I like their insight which I think helps explain today’s low yields. CAPM is a theoretical concept that can be used to calculate the return investors should require to own an asset (the higher the return investors need, the lower the price they should be willing to pay to own that asset). Two key components are (1) how risky is it, and (2) how correlated is it with other assets.
So to apply this to stocks, if a stock is highly risky (i.e. volatile) investors will need to make a higher return to own it so it’ll trade at a lower P/E or P/BV multiple than if it was less risky. And if the stock isn’t correlated with other stocks, it’ll be more valuable because it’ll spread the investor’s risk around through diversification. CAPM holds that if you know these two features of a stock (or in theory any asset) then you can figure out its correct price. Markets and individual stocks routinely act differently than this and few people think about CAPM when they’re trading, but large amounts of capital are invested over the long run based on CAPM.
Prior to 2007-08, the world had been getting progressively less risky, at least in terms of changes in global GDP. We had a global bull market from the early 80s with a few stumbles along the way and bond yields fell steadily. I remember back in 1987 rising bond yields caused the ’87 stock market crash, but it’s been a long time since bond yields drove equity markets.
In recent years the market’s become conditioned to expect the Fed to cut rates at the first sign of trouble, and this has caused bonds to zig when stocks zag. That is really the insight of Palazzo and Nobili. As Treasury bonds have become a more reliable safe haven during bear markets, this has made them less correlated with stocks. A lower correlation, in the CAPM world, means investors should have a lower required return for bonds, or in other words are happy to own them at lower yields than might have been the case ten years ago.
Traditional risk management uses historical relationships amongst the securities in a portfolio to calculate how much risk an investor is taking. Holding Treasury bonds can make a portfolio less risky than holding cash, since bonds increase in value when stocks fall while cash does nothing. This was most dramatically true during 2008-09, as can be seen in the chart below.
What this means is that if at some point we enter a time when bond yields start rising because of fears of oversupply, inflation, absence of Chinese buying etc., many investors will discover that they have a lot more risk than they thought because both their stock and bond investments will be falling together. If bond prices become more correlated with stocks (which they would if a bear market in bonds was leading stocks lower) a lot of rethinking about risk will need to be done. There’s no reason to think we’re at that point today (although the paper concludes that bond yields need to rise).
However, at some point bonds will lead the stock market’s direction rather than follow it, and as a bond trader once memorably said to me describing his bearish outlook many years ago, “down will be a long way.”
click to enlarge
Source: Bloomberg, Federal Reserve
Disclosure: No positions