TLT: Remember When Treasuries And Equity Had Negative Correlations?

| About: iShares 20+ (TLT)

Summary

TLT is a high-duration treasury ETF.

The main reasons for buying long-term treasuries in the past were to create protection from a fall in equity markets and to receive interest income.

The flattening of the yield curve has been driving capital gains to bonds while sending more investors to buy stocks in search of yield.

The iShares 20+ Year Treasury Bond ETF (NYSEARCA:TLT) is indicating precisely what is wrong with the market right now. While the ETF is a very solid treasury fund with great liquidity and a reasonable .15% expense ratio, the long-term correlations are breaking down. Over the last few years we've seen negative correlations when using short periods for measuring returns but the longer term story is one that should be very concerning to investors.

Portfolio

The portfolio is stuffed with treasuries that have more than 20 years to maturity. That should be pretty clear.

Price Chart for Correlation

The following total return chart for SPY and TLT demonstrates the major problem with the correlation. I started the chart with August 2002:

Click to enlarge

The negative correlation from a short-term perspective remains very clear. The S&P 500 goes up and TLT falls. When TLT is rising, the S&P 500 is falling. That works out great for the hedging nature of the portfolio but then it all started to break down.

The average of the two in July 2010 is just a hair over the line for 50%. Essentially that is saying that an investor starting with an equal weight portfolio and never rebalancing it would be up 50% after about 8 years. This is period includes one drop in the market. If I were to use the start of 2008 when SPY had dipped but not crashed, the result was still a line running right about 50%.

In less than 6 years, starting with July 2010, we moved from an average of about 50% to an average of 181.94%. Granted the compounding power should cause the chart to demonstrate faster returns towards the end since the initial investment is fixed. To correct for that, I duplicated the chart but set the starting point to be an equally weighted portfolio from July 2010. This would essentially rebalance the portfolio on that date.

Click to enlarge

In about 6 years the average return is 86.67%. While negative correlations are still visible in this chart, they don't appear to be near as strong as they were previously. The lack of a stronger correlation suggests that the hedging value of long-term treasuries may be weakening.

TINA

The bigger problem with the weak yields on these long-term treasuries is that it enforces a mindset of TINA for investors. TINA stands for "There is no alternative". If ever there were a phrase to set up a bubbling in investing, it would be the idea that there was no alternative. Investors are pushed further and further out into higher credit risk bonds and into equity securities.

As long as treasury yields remain exceptionally low, it is hard to argue that the stock market must command a fairly high valuation because dividends remain a viable source of income and the sales and earnings of corporations should grow with inflation.

Federal Reserve

The Federal Reserve is stuck in a fairly terrible situation, though many other central banks are also facing similar challenges. They would like to be able to raise interest rates and they can see the danger of investors pouring into higher yielding asset classes, but the employment and inflation figures are not strong enough to justify raising rates. If their job were simply to smooth out gyrations in the stock market it would allow them to sell off bonds and raise short term rates. The stock market is not one of their mandates, but they seem intent to try to manage it. Therefore, we end up with a Federal Reserve that is intent on raising rates and trying to twist the employment numbers to fit the narrative.

Conclusion

If the Federal Reserve were able to push rates higher across the yield curve, it would clearly drive large losses for TLT. The problem for investors is that it appears likely that such a situation would also push the equity market materially lower. The initial strategy of mixing SPY and TLT was a great way to reduce volatility while achieving a respectable return, but it seems unlikely to hold up if returns are measured over the next several years.

Welcome to the world of TINA.

Treasuries seem unlikely to protect the portfolio as effectively as they did in the past and they certainly don't pay the same yield.

Disclosure: I/we 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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