This is going to be the simplest Seeking Alpha article I have ever written. Its insight is neither amazing nor subtle. It's a simple fact which snuck up on all of us. It's important, though, and it happened right before our eyes and continues to hide in plain view. It's also the kind of fact no sell-side market pontificator can profit from, or has an interest in pointing out.
It may or may not change your view of the correct personal asset allocation. In my case it made me a bit more comfortable with the allocation I already have. It may do the same for you, or it may nudge you just a bit in the direction of reducing market risk.
This is the key point: you can get a completely safe return from the 2-year Treasury Note which is above the S&P 500 dividend yield. Not only do bonds now yield more than stocks, but so does every maturity of Treasury debt down to six months. Since 2014, the 2-year yield has climbed from next to nothing (less than 25 basis points) to almost 2.5%. That's enough yield to matter.
For the sake of simplicity let's use a 50-50 portfolio. That's my own asset allocation and has been for a couple of years. Let's also assume that the 50-50 portfolio is made up entirely of an S&P 500 index fund and near-cash. That's not quite me. I don't use the index fund. If you have a portfolio of stocks and funds from which you expect a materially different return from that of the S&P 500, you can make your own adjustment. The arithmetic remains the same.
Total portfolio return equals the percentage you have in the 2-year Note multiplied by its yield plus the percentage you have in the S&P 500 index multiplied by the total return of the index. Going back a couple of years to the time when available cash returns were virtually trivial, a 50-50 stocks/cash portfolio would have gotten you half the S&P return. If you did better than that it was by good luck with sector or stock selection.
The other half of the S&P 500 return - the half you didn't get - is the price you paid for stability and insurance. It reduced risk and made cash available for unexpected needs or opportunities. That's expensive insurance, but for old folks like me the conventional wisdom argues in its favor.
The implications of this simple equation have now changed very materially. I'll state those implications in four ways:
- Holding cash or something close to it now costs you a good bit less.
- In some scenarios it may make up a meaningful part of your overall return.
- The expected return on a 50-50 stocks/T-Note portfolio has increased by over 1%.
- The 2-year Treasury Note now performs something of the role bonds once played - an uncorrelated asset class with returns which are lower than the expected long term return of equities but not insignificant.
You can now get just under 2.5% from the 2-year Treasury. Stop. Read that line again. Think about it.
Why two years? It's partly because I believe the next two years are likely to provide some clarity for long term investors. While some economic indicators are hot and getting hotter, others are showing some of the early warning signs of a rollover. There's a bit of a global slowdown in industrial growth (with special reference to Europe), some overhanging trade issues, and a modest year-to-date decline in Citigroup's economic surprise index. These may be passing worries, but the current expansion is indisputably long in the tooth. We should get clarification by market action and/or clear economic signals within two years. Clear recession indicators, including the often mentioned yield curve inversion, have a lead time which fits the two year window pretty well.
Nothing in the above paragraph should be taken as a prediction. It's just a presentation of the argument that if risk is a concern of yours, the next two years are a period in which risks appear fairly high. It is not so long, however, as to worry too much about tying up your capital so as to lose out on longer term opportunities.
To me, the 2-year Treasury is the sweet spot. Maturities further out on the flattish yield curve offer increasingly poor return for the amount of time they tie up your money. So no bonds or longer dated notes for me. I wouldn't even reach for the additional 14 basis points offered by the 3-year. Three years is on the far side of my horizon. I know that a couple of smart guys on this site disagree and believe in always having a bond allocation despite the meager yield, and I get their arguments, but still respectfully disagree.
Why not the 1-year? It yields 2.25%, almost as much as the 2-year. Here's the thing: the 2-year locks the rate in, for good or ill. At least it does so psychologically. It's a nuisance to sell T-Notes, and you have to absorb the spread. Two years gives enough time for a recession to unfold or the character of the equity market to change. My real reason may be to reinforce my own discipline: it's like Odysseus sailing past the sirens while lashed to the mast so he can hear the song without succumbing. If you know that you are inclined to jump on small dips, you may wish to tie yourself up similarly.
And why not CDs? You can maybe get 25 basis points more than you get from Treasuries, but you are locked in somewhat more firmly. I don't rule it out but I would only do it for capital I am willing to lock away absolutely for the period.
Now let's consider a few What-Ifs. What if the market goes up at its normal historical rate? What if the market does nothing for two years? What if the market takes a normal corrective hit? Here are three scenarios.
Scenario One: Equities Have A 20% 2-Year Return
My own asset allocation is 50-50 equities/cash (or near-cash). This extremely conservative posture is in part because I will be 74 at the end of the summer. On the other hand I still work and have both a pension and Social Security. I might go as high as 90% equities if for some reason the market got amazingly cheap.
I don't expect to be able to do that. I don't see events on the horizon that would produce the kind of decline needed to make it dirt cheap - dirt cheap for me being the kind of cheap in which you might buy the index just for the dividends. Nevertheless, 50% of my portfolio not in equities is a reserve from which I might under proper conditions buy stocks and/or longer bonds.
A 20% total return for the S&P 500 over the next two years would be close to the long term average. With the near-zero rate obtainable on short Treasuries a couple of years ago, a 50-50 portfolio would have produced half of that, a 10% return over two years or 5% annually.
What does the 2.5% return on near-cash do to improve that?
With 50% of your investable assets invested in the 2-year Treasury, the two-year total portfolio return goes up to 12.5%, or 6.25% per year. This may sound small, but to me it is meaningful enough to reinforce my conviction about my current allocation. A lot of costly active management is applied in the equity market in the hope of getting that amount of incremental return. The uptick in Treasury yields is giving it to you for the taking. You can easily generate your own numbers plugging in your personal asset allocation.
But does the increased near-cash return suggest tilting your portfolio in the direction of less risk? Let's consider two other scenarios - that the S&P 500 goes nowhere over two years and returns only its dividend yield, and, just to use a symmetrical number, that the S&P 500 ends up down 20% after two years.
Scenario Two: The S&P 500 Goes Nowhere
This is the simplest scenario to understand. If the S&P 500 goes nowhere for two years - or goes everywhere, up and then down, down and then up, but ends up at its current price - what you get is its dividend yield of 1.87%. That's the dependable bond-like yield of stocks, which in days of yore was the main reason for owning them.
This 1.87% is, by arithmetic, .62% less than the current yield of the 2-year Treasury. What it means is that the measly 2.5% return of the 2-year Treasury will not only have provided heart-attack insurance but will have accounted for more than half of the total return for a 50-50 portfolio.
This scenario also suggests another important point. If the S&P 500 goes nowhere for a couple of years, it gets cheaper. It will have gotten about 20% cheaper based on normalized earnings and dividends. I back into that number on the basis that the S&P return "normally" equals about 10% a year. Its yield will also have increased a bit, moving it up toward 2%. In short, you may, after two years of a flat market, decide the equity index is cheap enough to buy.
Longer bonds, too, are likely to have gotten cheaper in a flat market. A very likely cause for flat performance in stocks would have been upward movement in interest rates, slowing the economy and leading to a contraction in equity valuations. The shift in value of stocks and bonds would likely be highly correlated. An increase of rates across the yield curve would, by trashing bonds, mark the end of the era of TINA - There Is No Alternative. The return available in fixed income would become more competitive with stocks.
The big news of the 2-year yield at 2.5% is that there is already an emerging alternative. It just hasn't been strong enough to suggest piling into bonds. You aren't getting paid much for duration. You could say more or less the same of stocks, which also have a duration sometimes stated as the inverse of their dividend yield.
If stocks and bonds go through a flat to down market together, it may well be because the same higher rate of return is being required of both. If that proves to be the case two years in the future, with the 10-year Treasury driven to a yield above 4%, I myself might take the chance to tiptoe back into a conventional bond allocation in my portfolio. In recent years I have doubted that there would be a rationale for owning bonds again in my lifetime.
Scenario Three: Equities Have A 20% Correction
It's in this scenario that a competitive return on an asset with fixed and short duration really shines. There's nothing like having an asset in your portfolio which plugs away doing its modest bit while the world of equities (and possibly bonds too) have a real correction.
A 20% correction is the general definition of a bear market (a term which matters less to investors than to news outlets). Most declines of this magnitude or greater are accompanied by recessions or at least economic slowdowns. We are overdue for both a recession and at least a minor bear market, but with present longer term indicators positive to mixed the earliest probable time frame for a recession is probably a year or two from now.
To go much longer than that without at least a mild recession would be surprising. A correction of 20% or more happens every 3.5 years or so (32 since 1900). We haven't had such a correction on a closing basis for nine years. A 20% correction is definitely out there in our future. We just don't know when, although it is reasonable to think that the market is now on the clock. We also know, of course, that the next event after a recession is a recovery.
Consider the 50-50 portfolio. If the S&P 500 is down 20% two years from now, the loss in portfolio value is moderated by the S&P dividend (1.87%) and the 2-yield (2.50%) - an overall 4.37%. That's the kind of risk reduction a bond position has traditionally provided. Your total portfolio is down less than 8%.
Currently, the 10-year Treasury improves upon the two year by only 45 basis points. That's hardly worth considering. In the event that stocks are down for reasons which also affect bonds (higher rates across the yield curve), the decline in the price of the 10-year would almost certainly wipe out the advantage in coupon yield. The 2-year with its similar yield and return of capital in two years may actually serve as better portfolio ballast than the traditional longer bond allocation.
I would be happy to wake up one morning two years from now with my total portfolio down 8% and the need to make the happy decision of how much capital to commit to longer duration assets and how to divide the first tranche of my reserve capital between the S&P 500 at 14 or 15 times earnings and the 10-year Treasury yielding 4%.
The market can of course take a tumble of more than 20% - sometimes a lot more. For a more detailed piece on committing reserves in down markets see this piece. A somewhat more nuanced and aggressive approach is laid out in this piece.
A Flexible Alternative
With a little sacrifice of yield you can use money market funds for greater flexibility. Vanguard's Prime Money Market Fund (VMMXX) has a yield of 1.81% as I write this, and their Municipal Money Market Fund (VMSXX) has a yield of 1.54%, which is better for taxable accounts and competitive with the 2-year Treasury if you pay taxes at a high marginal rate. In that case you might stay with the Municipal Money Market Fund in taxable accounts. The rates on both these funds have recently been increasing almost daily, and if the Fed follows through along the lines of its projected increases, they will continue to do so.
I talked about these alternatives in an earlier piece. To a degree, I think, I prefer the 2-year Treasury because it so well approximates the traditional role of a bond allocation. That's more psychology than math. I was interested that an earlier commenter shared my need to be lashed to the mast. Like the commenter, my character is improved when I bind myself with strong ropes.
What Could Make This Strategy Wrong?
In absolute terms, nothing. You'll get your money back with 2.5% annualized return. The major potential regret is opportunity cost. This is true for any strategy which locks up your capital for any duration greater than zero.
The only real question is whether to execute this strategy right away or wait to see if another Fed raise or two lifts the yield on the 2-year further. That's a real possibility. Buying the 2-year now says that 2.5% is good enough and two years in a holding pattern is likely to be about right.
The argument for waiting a while may be reinforced by the fact that the 2-year yield has trended steadily upward for two years, and the trend has in fact accelerated over the past year. Looking at the chart, there is no evidence that the 2-year rate has peaked, or that it will level off.
If you have worries about this, you might edge into a ladder with the 2-year while keeping cash for potential future commitments in money market funds. Or you might just settle for the money market alternative. The return on money market funds doesn't quite measure up to what you get from the 2-year, but you weigh that against the zero duration and greater flexibility, as well as the chance that the Fed follows through aggressively and pushes all shorter term rates much higher.
The key points of this article are contained in the first two sections. The 2-year Treasury Note now offers a yield which is greater than the dividend yield on the S&P 500. This enhances the defensive role your short term fixed income allocation can play.
If you have avoided commitments to longer term bonds as I have, you can now think of the 2-year Treasury as playing the role that a bond allocation plays in normal times - portfolio ballast and a modest but meaningful return. Knowing these facts may simply reinforce your convictions about a strategy involving a large cash reserve or it may give a modest nudge in the direction of rebalancing or increasing your reserves using short duration fixed income.
Disclosure: I am/we are long VMMXX, VMMSX. 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.