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Many writers like to discuss the concept of reversion to the mean. For instance, if the P/E ratio for the S&P 500 is trading at a 25%-plus premium to its historical average of 15, stock prices might fall dramatically to restore the P/E balance.

Similarly, there have been many times when the heralded benchmark has traded at a 15%-20% discount. Even at the beginning of 2012, the S&P 500 traded at a 15% discount with its P/E near 13. Eventually, as the price climbed above 1350, the S&P 500 returned to its 65-year mean.

This same idea of revisiting an average, or a mean, has rarely been discussed with respect to U.S. treasuries. Is it because the “risk-free” asset gets a pass? Is it because ”reversion” is a stock-only concept? And if the Fed can be blamed for unintentionally engineering the dot-com bubble in 2000 as well as the housing bubble in 2006, isn’t it possible that the quantitative easing/rate policy/”twisting” may be creating a treasury bond bubble here in 2012?

The norm/average/historical mean for longer-term treasuries is roughly 300 basis points plus the rate of inflation. Recognizing that inflation has been running at 2.25% over the prior five years, we’d expect the 20-year government bond to serve up 5.25% ... not the mere 2.3% that we see at present.

Granted, few expect the demand for treasuries to weaken any time soon. The fact remains that mom-n-pop investors are petrified of stocks and the Fed is “twisting” in the wind.

Still, what will happen to Treasury Bond ETFs when reversion to the mean does occur for bonds? What would a 3 percentage-point rise (300 basis points) in the yield of the 20-year do to the iShares 20-Year Treasury Bond Fund (NYSEARCA:TLT)?

Click to enlarge

(click to enlarge)TLT 200

With a bond duration of 15.5 years, TLT might lose 15% for every 100 basis point increase. In theory, at least, TLT could lose 40% if rates moved 300 basis points higher. Those that earned 30%+ in 2008 when rates plummeted may not even realize what could happen in a skyrocketing rate environ.

Will it happen with the Fed making sure to participate in bond purchases? No. Is a mass exodus from the mom-n-pop investor likely? Nope ... they feel safe.

Yet loading up on Treasury Bond ETFs will not protect one from bearish losses when bonds revert to their mean. It follows that it may make sense to be careful about your exposure to “risk-free” Treasury Bond ETFs. Participate if the balloon keeps expanding, but use the trendlines to identify your exit point.

Disclosure: Gary Gordon, MS, CFP is the president of Pacific Park Financial, Inc., a Registered Investment Adviser with the SEC. Gary Gordon, Pacific Park Financial, Inc, and/or its clients may hold positions in the ETFs, mutual funds, and/or any investment asset mentioned above. The commentary does not constitute individualized investment advice. The opinions offered herein are not personalized recommendations to buy, sell or hold securities. At times, issuers of exchange-traded products compensate Pacific Park Financial, Inc. or its subsidiaries for advertising at the ETF Expert web site. ETF Expert content is created independently of any advertising relationships.

Source: Reversion To The Mean In 'Risk-Free' Treasury Bond ETFs