Baseballs And Bonds: How The Law Of Gravity Applies To Each

Includes: DTYL, DTYS, TYD, TYO
by: Steven Pope

Throughout his 18-season major league baseball career, Roberto Clemente tormented speedy base runners from his right-field post. Clemente is widely regarded as having one of the best arms in MLB history and was notorious for causing runners to second-guess taking an extra base. However, while the hall of famer was capable of throwing the ball with incredible power and accuracy from his position - 350 feet from home plate - no one would suggest he would have been nearly as effective if he needed to throw the ball 1,000 feet. The obvious reason: even a baseball thrown by Roberto Clemente is subject to the law of gravity at some point and will eventually succumb to this unassailable physical law and fall back to earth. Thus, I would argue, lies the similarity between baseballs and bond returns.

Treasury bonds enjoyed historic returns in 2011, as the 10-year bond posted its ninth best calendar year return since 1928. Given such returns it is not surprising that Treasuries were the best place for investors' money last year. Yet, much like a baseball that eventually loses speed and altitude, so too will the prices of fixed rate bonds. This view that bond prices will not likely repeat last year's performance is largely mathematical, rather than prognosticative. In order for prices to continue to rise, the yield on bonds must fall. Since the yield on a long Treasury bond is already around 2% - a historic low - there is not much room left for bond yields to fall without pushing rates into negative territory. In fact, in order to replicate last year's performance, the yield on 10-year Treasuries would have to go negative!

Due to their fixed nature, bond investors cannot expect to receive price appreciation into perpetuity, as is possible by an equity investment. Unlike corporate stockholders who own a portion of the company, bond investors own a claim on a specified periodic stream of income and therefore deal in a world of much less uncertainty. For bondholders, the ongoing concern of a public corporation is replaced with a final maturity date. A fluctuating residual dividend is replaced with a fixed coupon payment, and the final termination value for the security is known with certainty. Stated differently, it is nearly impossible to predict the 10-year return of a stock. Yet, it is entirely possible to know the rate of return expected on a bond. A 10-year Treasury, purchased with a yield to maturity of 1.90%, means an investor will earn an average of 1.90% on their money over 10 years…no more and no less.

So what are the key takeaways from this analysis? First, be careful not to look in the rear-view mirror on asset class returns and infer the performance will be repeated. Skittish investors and aggressive government purchases forced bond prices to spike last year and pushed yields to an all-time low. While it is certainly possible that Treasury prices may continue to increase in the near term, a repeat of 2011 performance is unlikely, as it would be nonsensical for investors to accept a negative yield. Second, be aware of the bubble that may be forming in some areas of the bond market. Despite some of the lowest yields on record, billions of dollars have been diverted from stock funds to bond funds since 2007. Finally, today's investors may be well-advised to consider opportunities in other asset classes. The long-term outlook for domestic stocks, for instance, appears promising due to strong corporate profitability and rich balance sheets, combined with attractive valuations.

Remember, no matter how hard a baseball is thrown, it will eventually reach an apex and arch back toward earth. The 'fixed' characteristics of fixed income securities ensure bond prices experience the same fate. Treasury securities may make sense for some investors this year, but should be assessed from their yield and credit characteristics rather than by how well they performed last year.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.