Treasuries May Not Be As Safe As You Think

by: Don Joe

A combination of fear, uncertainty, and Federal Reserve actions have brought the yield on the 10-year Treasury Note to 1.9%. Unless you believe we are heading for a Japan-like deflation, lending money to the Federal Government for 10 years at this rate will almost certainly lead to negative real returns. The Federal Reserve seems committed to low interest rates. Part of its objective is to push capital in to riskier investments by lowering the returns obtained from treasuries. However, there is a potential flaw in this plan.

With the Fed committed to keeping rates low, it is signaling to the market that yields will not rise and the price of treasuries will not fall, which may cause some investors to stay in the treasury market, accepting the lower yields for increased safety and certainty. When interest rates finally are allowed to rise, there is the potential for a significant outflow from treasuries, which could possibly happen very quickly as investors try to sell before prices fall. The possibility of a precipitous fall in treasuries is evidenced in the below chart, where a mere change in language by Ben Bernanke caused the 10-year yield to move from around 2.0% to a peak of about 2.4% in just days.
10 year Treasury yield

Holders of treasuries could be playing a dangerous game of chicken in which they may find everyone trying to head for the exit at once. They may have significantly more risk in their portfolio than intended as they are exposed to interest rate, inflation and duration risk. One solution to this problem is to act as the Fed expects: Seek higher returns in riskier assets.

Symbol Name Yield
SPY SPDR S&P 500 1.87%
VWO Vanguard MSCI Emerging Markets ETF 2.12%
DIA SPDR Dow Jones Industrial Average 2.32%
VOX Vanguard Telecom Services ETF 3.09%
VPU Vanguard Utilities ETF 3.67%
VGK Vanguard MSCI Europe ETF 4.15%
VPL Vanguard MSCI Pacific ETF 2.98%
EFA iShares MSCI EAFE Index 3.12%
VNQ Vanguard REIT Index ETF 3.36%
AMLP ALPS Alerian MLP ETF 6.01%
PSP PowerShares Global Listed Private Equity 6.68%
ENY Gugenheim Canadian Energy Income 3.24%
MBB iShares Barclay's MBS Bond 3.27%

To illustrate how low the 10-year yield really is, it should be compared with other assets. The S&P 500 yields roughly the same as the 10-year treasury. Even if you have the bleak outlook that stocks will remain flat for the next decade, the returns for SPY will be comparable to 10-year T-Notes. If you believe there is a chance stocks will rise over the next decade, perhaps they are a better investment than T-Notes. If you want a little more safety there is DIA, the SPDR Dow Jones Industrial Average ETF, which has a yield of 2.32%. Want more chance for price appreciation? The Vanguard MSCI Emerging Markets ETF offers a yield of 2.12%, still greater than 10-year treasuries. For those of you brave enough, European stock indices offer a yield greater than the 30-year T-Bond. The future cash flows of these ETFs may not be certain like a 10-year treasury, but the upside potential is certainly greater.

Alternatives such as MLPs, private equity, Royalty Trusts, BDCs, and REITs have their own characteristics that separate them from stocks and they all offer significant yields, which can replace income lost to artificially low interest rates. Theses investments may require further research before purchasing.

It is difficult to make a case for holding Treasury Notes and Bonds. The only scenario that justifies the duration, inflation and interest rate risk would be a prolonged, Japan-like deflation. With Ben Bernanke's statements on avoiding deflation and the Fed's recent history of monetary policy, along with other fundamental factors, such a scenario seems unlikely.

Even with the poor prospects found in the treasury market, many investors do not know where else to turn given the amount of fear associated with owning stocks. While buying based solely on yield may constitute a poor investment strategy and risks need to be accounted for, it may be best for investors to look at any pullbacks in the stock market as a chance to sell expensive treasuries and buy inexpensive stocks. After all, the idea is to buy low and sell high, isn't it?

Disclosure: I am long VPU, VOX, VWO, VGK, VPL.