Several Reasons To Turn Bullish On Treasuries: Are They Good Enough To Make Them A Buy?

Includes: EDV, ZROZ
by: DoctoRx

Introduction: After a promising beginning to 2013, the Treasury bond complex (which includes notes of 1-10 years and longer-term bonds) has suffered serious harm. Given historically extreme rates on the low end of the spectrum, this bear market could well mark the start of a secular bear and thus these and other bonds perhaps should be shunned. This article evaluates the bullish side of the case and suggests a strategy that investors may want to consider.

Bullish arguments:

Point 1: Given near-zero short-term rates, which are at record lows for a record 5-year period, there is no reason to think that the Treasury bond bull market should not last longer than the prior one. Per old Louise Yamada data, the longest prior bond bull market in the U.S. lasted 36 years. (This is from memory, and the chart I saw this on is long gone.) Thus this bull may not have ended, and could run for 40 years or more. After all, the bull market that began in 1981 was from an extraordinarily high interest rate. The 10-year bond rate was above its historical average around 4+% as recently as 2008. A "true" bull market in bonds from historically normal levels only began in late 2008, after all. This is seen in a chart:

10 Year Treasury Rate

(Click to enlarge)

Current 10 Year Treasury Rate: 2.88%

At market close Fri Dec 6, 2013

Mean: 4.64%
Median: 3.92%
Min: 1.53% (Jul 2012)
Max: 15.32% (Sep 1981)

Point 2: A recent article makes several bond-friendly points. These include:

Honed by 15 years of falling consumer prices that burnished the appeal of fixed-income assets in Japan, the Asian nation's bond buyers are amassing long-term Treasuries (BUSY13) as disinflation emerges in the U.S. Led by Mizuho Asset Management Co., at least five money managers that oversee a combined $236 billion are snapping up Treasuries due in about a decade as inflation-adjusted yields approach the highest level since 1998 relative to Japanese government bonds...

"There's tremendous deflationary pressure in the U.S.," Yusuke Ito, a senior fund manager at Mizuho Asset, which oversees about $32 billion, said in a telephone interview from Tokyo on Dec. 4...

With the annual inflation rate at 1 percent in the U.S., real yields for 10-year Treasuries are now about 1.85 percent, data compiled by Bloomberg show. That's about 2.3 percentage points more than in Japan, where the inflation rate exceeds the 10-year bond yield by 0.43 percentage point.

As recently as June, yields adjusted for consumer-price gains favored Japanese debt...

The article goes on to discuss low and falling U.S. inflation:

Since reaching a three-year high of 3.9 percent in September 2011, consumer price gains have slowed. In October, prices rose 1 percent from a year earlier, according to a Nov. 20 Labor Department report.

The Fed's preferred measure of U.S. inflation, the personal consumption expenditures deflator, showed last week that prices rose 0.7 percent in October, the least since 2009. The gauge has failed to meet the Fed's 2 percent target for 18 months.

A summary of the above is that in Japan, Treasuries are now a bargain. Also, in the U.S., short term rates of only around 0.3% on the 2-year note are below inflation, but rates on the 10-year note are above inflation. Putting these two points together, along with high valuations on U.S. stocks, there are now reasonable fundamental arguments for investors to put new money to work in the Treasury bond complex in the 10-year maturity range.

Point 3: Speculators in the bond futures market are at extreme levels of bearish sentiment. (This may be related to the extremely low levels of bearish sentiment on stocks that investment advisers are showing.)

Per :

A longer-term view from the same link shows this as well:

In these graphs, the green line represents the commercial interests, who take the opposite side of the trade from the large speculators (red line) and small speculators (blue line).

All market participants in the futures markets are nowadays presumed to be sophisticated, so it is incorrect to assume that the speculators are dumb money. My point is that in the context of the earlier arguments, the speculators are now arguing against the fundamentals of the bond market as well as against huge amounts of Japanese money that is transitioning from their home bond market into the underperforming U.S. market. My "take" is that bond-bearish speculation is now a reflex but may, surprisingly, be a bad idea based on both fundamentals and evolving supply-demand dynamics. (Note the Federal deficit as a share of GDP has returned near "ordinary" levels, which should lead the Fed to print less money by shrinking its QE program, which should lead to further disinflation.)

At least since the fall of 2012, money managers polled by Barron's in various quarterly surveys have been consistently bearish on bonds. This view continues. My view is that relative to U.S. stocks, Treasury bonds and high quality municipal and corporate debt are both safer and have similar prospective yields and are thus superior investment alternatives.

Point 4: The long-term graphical trend in T-notes remains in effect. From

The trend, after all, is your friend until it ends. Treasuries remain in a long-term bull market until the above chart is clearly broken. What has occurred since the interest rate lows of a year and a half ago appears to be ordinary backing and filling.

The 30-year bond also is respecting its trendlines. Also from

I like the (speculative) chances that in a few months to years, rates again break to new all-time lower lows. It can be argued that a true bull market in bonds did not begin until Lehman Brothers collapsed in September 2008.

Is the time right to put money to work in bonds?: This is a more difficult question to answer than the simpler one of whether T-notes are now reasonable buys.

My response is that for taxable accounts, there is good relative value in tax-exempt bonds, especially in the 20 year maturity range. Very high quality munis are trading around Treasury yields, but have similarly negligible chances of default but are exempt from Federal taxation.

Regarding Treasuries, I believe that given it is now six years since the prior recession began, there are good reasons to hold the most liquid deflation/disinflation hedge in existence. Stocks now look chancy on a 7-10 year basis to me, and cash continues to look like trash as a long-term asset class. Gold? Maybe. So, initiating a position in Treasuries with maturities of ten years of longer provides a positive return after inflation (as defined by the Fed), while guaranteeing principal and affording the speculative possibility of decent capital gains if rates fall enough.

Investment choices: Investors who do not care much about current income can increase their total return possibilities by purchasing long-term zero coupon T-bond funds. The two relatively liquid ETFs I know in this category are the PIMCO 25+ Yr Zero Coupon U.S. Treasury Index ETF (NYSEARCA:ZROZ) and the Vanguard Extended Duration Treasury Index ETF (NYSEARCA:EDV). Both are well into bear market territory. When possible, they do return money to shareholders.

Various other funds invest in Treasuries. The iShares complex includes the well-known funds with symbols such as TLT for very long-term bonds and TLH for intermediate term bonds.

Individual bonds may easily be purchased through a broker, including discount brokers.

An almost uncountable number of alternatives are available in the municipal complex.

The stock market as an alternative to bonds: Stocks have high valuations by numerous historical criteria and low 7-10 year prospective returns according to Jeremy Grantham, John Hussman, Value Line and many others. My opinion is that the long-term downtrend in interest rates has enabled the long-term uptrend in stock valuations. Thus a worsening bond bear market, which could go hand in hand with improving GDP growth, could be a serious challenge for stock total returns. On their merits, stock market dividend yields are again deep in bubble territory. Per

S&P 500 Dividend Yield

(Click to enlarge)

Current Yield: 1.91% -2.14 bps

4:30 pm EST, Fri Dec 6

Mean: 4.43%
Median: 4.37%
Min: 1.11% (Aug 2000)
Max: 13.84% (Jun 1932)

As the above graphs and supporting historical show, historically stocks and the 10-year note had similar yields. With the bond now yielding almost 100 basis points more than stocks, stocks are now overpriced relative to bonds on this metric, in addition to being inherently more volatile, outside of an episode of hyperinflation that gold bugs have been predicting since QE 1 but which has not happened.

Bearish arguments: There may be no major asset class for which the bearish arguments are so well known and so well accepted. Some of these arguments are that interest rates are so low as to be bizarre when viewed in the context of the ability of the government and its central bank to monetize any amount of debt it wants to create any level of inflation it desires. A related argument is that the deficit and unfunded governmental liabilities make debt monetization almost a necessity. A different argument is that on a multi-decade time frame, stocks continue to retain good value. Stocks, after all, have both bond-like and inflation hedge-like characteristics.

Summary: It's now reasonable to assert that high-quality Treasury, municipal and corporate bonds are roughly equal to stocks on a 7-10 year forward total return basis but have much lower durations and are therefore superior on a risk-reward basis. The structural decline in interest rates remains in effect. The Fed funds rate, which is supposed to be a free market rate, remain around 10 basis points. The economy has been assisted by extraordinary governmental support (which includes the government agency known as the Fed). There is no strong evidence that the economy can come close to sustaining a steady interest rate advance.

In view of the above, I believe that interest rates at the level of the 10-year T-note (2.85%) have a reasonable chance of providing positive returns above the inflation rate. It will take years of dividend increases for the S&P 500 dividend yield to simply make it to the 2.85% yield level of the 10-year note, and many more years to merely average 2.85%.

In my view, everything except actual cash or near-cash return on investment is a trading price and subject to material change without notice and is therefore speculative to one degree or another. Cash in deserves cash back in return. Very low dividend yields provide no margin of safety for stock market investors; at least cash is safe while yielding only a small amount less than stocks.

Conclusion: Overall, the bond complex is hardly a pound-the-table buy but is now a reasonable investment choice for U.S. investors who, naturally, do not wish to invest a large proportion of their funds in foreign securities.

Disclosure: I am long EDV. 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.

Additional disclosure: Not investment advice. I am not an investment adviser.

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