- Bond yields have cratered in the US.
- The immediate cause was the spread of the coronavirus that causes COVID-19.
- However, this move fits with multiple trends and still looks to me to have more 'legs,' which could reward investors with capital gains.
- The nature of Treasury debt, or perhaps "debt," is discussed.
- Also, the drop in yields to levels below inflation may make gold a good investment now.
As a longstanding bond bull, I'll just mention that the same structural factors pushing rates downward remain in force, including but not limited to these:
- fertility rates consistent with declining populations
- aging population (higher propensity to save, and save safely)
- "good deflation" from increasing share of high tech in the economy
- attractive differential between US bond rates and those in the EU and Japan
- very high valuation of equities.
- the Fed's propensity to make sure that "cash is trash."
One point I have not emphasized is the very special nature of central government debt, with specific attention to the United States. The next two sections relate to my view that:
US government debt is not really debt: background
Supposedly in a possibly drunken conversation in the 1920s, F. Scott Fitzgerald opined to Ernest Hemingway that "the very rich are different from you and me."
And supposedly, Hemingway retorted, "Yes, they have more money."
Just as there are different points of view about wealth and the wealthy, there are different ways to think about money. The traditional ideas about money were exemplified by gold (GLD). Money such as a precious metal was supposed to have been:
- a store of value
- used to settle debts and make payments
- found in many parts of the world, so no one could monopolize the supply.
If I left some key points out, please forgive me and comment appropriately.
Under that principle, until almost the end of the 20th century, even though periodically some countries went to unbacked paper money, there was always a major country that was on a gold or silver (SLV) standard, or a bimetallic one. If I remember correctly, in the late 1990s, Switzerland dropped its partial gold backing for its currency (the Swiss franc or CHF), and with that, the gold/metal standard was gone from the earth. The triumph of central governments and their (mostly) captive central bankers was complete.
In other words, central government debt is very different from debt that individuals or companies owe. The government has access to the (electronic) printing press, and in the case of the US, the Feds only owe money denominated in USD, so default would be a choice rather than imposed from external creditors.
The mechanism of maintaining control of the money supply is via debt. But, to repeat, my perspective as an investor and saver is that:
US government debt is not really debt: the Fed as middleman
Again focusing on the US, which set much of the world on a de facto dollar standard beginning with the Bretton Woods conference in 1944 and an almost de jure USD standard when President Nixon "suspended" the convertibility of gold into dollars in 1971, this global, as well as national, currency is spent into being by the Federal government. Large financial institutions buy the debt and parcel it out to smaller buyers, who naturally count it as a financial asset. But the government has no intention of paying the debt back. Instead, the Federal Reserve buys previously-issued debt (it is barred by law from buying the new issuance) with... electronic money it creates "out of thin air."
The Fed then collects interest on the debt it has owned but only paid for with dollars that have a core profit margin of 100%. After the Fed deducts its operating costs, it ends up being quite a profitable institution. What does it do with its profits? Why, it passes them all back to the same Federal government whose debt it profited from.
In other words, eliminating the intermediate actions, the government has issued its own bank notes, sterilizing them through the process described above.
This is a more sophisticated version of the pre-Fed days when the Treasury issued money. As the government describes in an online history of the USD:
United States Notes
Congress authorizes a new class of currency, known as "United States notes," or "Legal Tender notes." These notes are characterized by a red seal and serial number. They continue to circulate until 1971.
Doing things through the more complicated intermediary of the Fed - the paper currency in our physical wallets are Federal Reserve Notes rather than the United States notes of pre-Fed days - has benefits. It allows the Fed to take the lead in setting interest rates, regulate bank lending, and do other important things. Of course, there is no free lunch, and the Fed is far from perfect in its decision-making, so there is downside from this arrangement.
In the very big picture, all the government and Fed need to do is maintain a modicum of confidence by the major financial institutions (which they regulate and periodically bail out), the public (over which the government has massive real and media influence), and the rest of the world (much of which runs on a USD standard) to keep this system going indefinitely.
As an example of how true it is in practice, that government debt is not debt that comes from Japan. The Bank of Japan, chartered in 1882, sets monetary policy and has pegged short-term rates near-zero for about 20 years. Despite a seeming mountain of central government debt, Japan's economy functions productively.
This can happen in the US, and I think that...
The trend is the US bond investor's friend
What has happened since the era of very big peacetime Federal deficits began with Reaganomics is that, as the pool of Treasury debt expands rapidly, the cost of rolling it over declines. President Trump made this point Saturday in an impromptu news conference. Basically echoing Warren Buffett's response to Standard & Poor's downgrade of US debt from AAA status in the summer of 2011, Buffett said that if there was such a thing, the US was an AAAA credit. Similarly, Trump pointed to the dominance of the USD and the size and strength of the US economy, and said that, therefore, the US government should enjoy the lowest borrowing costs of any government. Of course, the flip side of that is that savers should be robbed faster than they are at present, but here's why I think that the comparables that drive financial markets point to even lower rates.
The main comps I point to are in Europe. The metric I use is real return on government debt. Take Germany as a first example. From Inflation.EU:
Chart - historic CPI inflation Germany (yearly basis) - full term
By CPI, Germany is running around a 1.5% rate. Yet, the German government was borrowing as of Sunday's Bloomberg News bond web page at around a negative 0.77% (-0.77%) for both 2- and 5-year debt.
Based on current CPI, that's a real return to savers of around -2.5% per year, every year. In contrast, even after a very large drop in rates, the US 2 and 5 year notes are in the 0.9-0.95% range, or about a -1.6% real return based on CPI of 2.5%. US rates could drop to about zero to offer a similar real return as German bunds.
Both in the US and Germany, the above rates are heavily influenced by expectations of central bank policy. The free market is most apparent in long-term rates. The 30-year German bund trades at -0.16% per year. Thus, in 30 years, 1,000 euros invested in this security would turn into a total of about 950 euros. Based on current CPI, the real return is -1.7% per year.
After another drop to new-record lows in yield, the 30-year US Treasury yields 1.68%, or a real return of about -0.8%. That would imply a projection of 0.8% nominal yield of the 30-year T-bond. Perhaps that would be reached if the current global economic funk and growing number of COVID-19 (novel coronavirus) cases really muck things up for a sustained period.
The above numbers are extreme right now but are in line with a summary point I made in a (longer-term) bond-bullish article 6 months ago, when bond yields were looking to be at a (? temporary) bottom after having plunged. The article was titled Why Bonds May Still Be A 'Buy' (Overview; Part 1 Of 3), and my prediction was:
Whether or not the US goes into recession this year or next, I think it is reasonable to conceive of the 30-year bond trading in a 1.0-25% range, with the Fed funds rate back to zero or negative.
Now, let's look at the long-term trend in this bond yield to further explain why I think the bond remains investable.
Why 2.5% now looks like the ceiling in yields, not the floor
This chart reflects rates on new issuance of Treasuries, thus the gap in the 2000s when the 30-year was not offered. Basically, rates have been dropping around 0.25% per year for decades. And based on comparables, I think it's reasonable to say that there is good reason to assert that this trend remains in force. Is it ahead of itself? Based on trendlines, yes, somewhat. However, just staying within the time frame shown above (begins in 1994), we have several non-recessionary examples of 200 basis point drops. Such a drop from the 2018 high would give a projection of 1.45% for the current move.
However, that peak was already 16 months ago. If we take a more recent peak yield, the reaction high near 2.4% reached Nov. 12, 2019, a fresh 200 bps drop gives a projected yield of 0.4%.
Finally, and importantly, another way to look at matters is that, beginning in the 1980s, yields noodled around for many years until forming a top and then noodled around some more in a new trading range. What happened over and over was that crisis lows in yields (often the crisis was in a non-US venue) yielded spike lows, which gradually moved from looking "too low" to forming a resistance ceiling. By that reasoning, the 2.48% panic low in December 2008 has moved from "too low" to a ceiling. So, I am going to examine what investors get if they buy a 30-year Treasury at a yield of 1.7% and then rates meander down to 1.0% in 4 years.
Contained risk and upside potential from a 30-year bond
Before I go further, remember you can take on repayment and liquidity risk and buy AAA-rated Microsoft (MSFT) or J&J (JNJ) bonds, or non-AAA-rates long-term bonds that yield more. If things go well, their total return will be higher than with Treasuries.
In the "worst" case, one owns a bond to maturity. For safety's sake, owning a non-callable long-term T-bond has certain advantages; it is simply a preservation of capital move, and price fluctuations may be ignored. But an upside is that the bond trades, either individually or as part of a fund, such as the iShares 20+ Year T-Bond ETF (TLT).
Using an Internet-based bond calculator, I find that a zero-coupon bond would be priced at $60 to mature at $100 in 30 years, compounding interest at 1.7% twice yearly. I further find that, in 4 years, the same bond would be priced at $78 to yield 1.0% 26 years hence. That would provide a total return of 30%, or about 7% per year if sold at that price.
A 1-year move to 1% would imply a 25% gain.
Note, the math is less exciting for traditional bonds that pay interest, but the trends are similar.
Risks to bond investing
Bonds can default in full or in part. They can "default" by inflation. They can underperform cash, stocks, real estate, foreign bonds, etc. They can become illiquid just when one most wants to sell them. Even a government guarantee may not really guarantee any outcome an investor or conservative saver may want. So, please be thoughtful and do not take anything said herein as encouraging you to make an investment decision.
A positive comment on gold
As government bonds in the developed world move to zero or negative real returns, meaning that corporate and municipal debt with strong credit ratings is getting there or has gotten there (depending on the regional markets) as well, the fundamental case for gold has strengthened. For now, I look at GLD (as a proxy for bullion) as tracking Treasuries:
I am long GLD and a lower-cost, somewhat less liquid ETF SGOL.
Given the overbought technicals in TLT, but the setback for gold at the end of the week, I am considering dipping into cash reserves to add GLD or SGOL soon, perhaps imminently.
Concluding remarks - long bonds for the short run (and maybe the long run)
In the old hit song, "three little words" meant I love you.
Without getting emotional, I will say that bonds have treated me well and have formed half of the "Goldilocks" paradigm of combined stock-bond investing that has worked most of the time the past 40 years.
For now, and without trying to predict the economic environment 10 or 20 years out, I will revamp that to the three little words comprising part of the title of this article: still a buy. But the asset class needs a wary eye kept on it.
Overall, I continue to believe that high quality bonds are not only ballast to secure a portfolio. In an August 2016 article, I presented this chart with my comments, relating to total returns from the long bond versus the S&P 500 (SPY):
Stocks up nearly 50X since October 1981; bonds up about 320X.
That's a CAGR of 12% versus 18%. How many people know that?
While stocks have narrowed the gap since then, the overall trend remains the same. And TLT has beaten the SPY over the past 12 months as well as during the past 36 months.
In conclusion, the little-known and often-hated bull market in long-term Treasury bonds may still be in force. With yields now so low but inflation hanging in there, gold may again be in a sustained bull market. It will be interesting to see if the SPY can keep up with those two relatively safe and relatively stable asset classes in the years ahead.
Thanks for reading and sharing any thoughts you may wish to contribute.
Submitted Sunday AM.
As of Friday's close, these were noted:
10-year T-note: 1.13%
30-year T-bond: 1.67%
Gold (futures): $1587/ounce
This article was written by
Analyst’s Disclosure: I am/we are long TLT, SPY, GLD, SGOL, MSFT. 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.
Not investment advice. I am not an investment adviser.
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