Government Bonds Have More Fun

Summary

• Government bonds are an institutional product used by pensions, insurance companies, foundations, and the most sophisticated high-net-worth investors.
• As a result, most financial folks have a bias against government bonds even though on a total return basis, they have outperformed stocks (S&P 500) by 3.5 times since 1980, with much lower volatility and capital loss risk.
• They are also one of the few assets that can offer negative correlation/diversification benefits when other asset markets deflate.

Andrii Yalanskyi/iStock via Getty Images

As I have explained many times, the finance industry charges the richest fees, packaging and promoting corporate securities (equities and corporate debt), as well as real estate and commodities. Because these assets tend to rise with inflation and fall with deflation, the bias inherent is to forecast inflation and further price gains, regardless of valuations or market cycle.

High yield or junk debt is also high-risk and thus traditionally has to pay higher yields to attract buyers. For this reason, it also pays fatter fees to the financial sector, which helps companies issue and sell this debt to the public.

On the other hand, government bonds are an institutional product used by pensions, insurance companies, foundations, and the most sophisticated high-net-worth investors. They do not need to pay high fees to the finance sector for retail marketing or distribution.

As a result, most financial folks have a bias against government bonds even though on a total return basis, they have outperformed stocks (S&P 500) by 3.5 times since 1980, with much lower volatility and capital loss risk. They are also one of the few assets that can offer negative correlation/diversification benefits when other asset markets deflate.

Case in point, as commodities, high-yield bonds and equities have been plunging of late, North American government bonds have been rising with the U.S. dollar. These moves are typical of periods where growth and inflation expectations (at a lag) are falling. The chart below, courtesy of The Daily Shot, shows the downward yield trends during past Fed tapering “Q.E.” efforts.

Even more than usual, portfolio managers and retail came into the latest risk-off selling with the highest concentration of equities and the lowest weight of bonds and cash on record, all while being the most levered ever. Ditto for CBOT traders who were massively net-short Treasuries in October.

All of this helped lay the conditions for a sharp rebound in treasury prices (falling yields). U.S. 10 and 20-year yields have moved back to levels seen in February and March of 2020. The Treasury market is not buying the inflation hype and is pricing weaker growth and deflationary weights in 2022.

Disclosure: No positions

Original Post

Editor's Note: The summary bullets for this article were chosen by Seeking Alpha editors.

Comments

[Gio Danisi]

Author: in 1980 a 30 years' treasury yield was how much? Where 12%? And then in 2010? Maybe 3? How could this be 3 times bigger than SPY? Do u know how much SPY was in 1980?

[Danielle Park, CFA]

See Government bonds have more fun (part two) here:

jugglingdynamite.com/...

[Tao Jaxx]

@Danielle Park, CFA Looks like I stole from him my below response about why people buy low yielding bonds lol
Hadn't seen it though.

[uofhmanoa]

@Danielle Park, CFA The returns on the zero coupon treasury are mathematically correct but misleading since zero coupon treasuries did not exist in 1981.

[uofhmanoa]

@Danielle Park, CFA And when the zero coupon treasury was introduced very few people bought them since it was a still brand new concept and many were still afraid of rising rates.

[JPC99]

I still dont get why anyone wants to own an asset with negative real yields.

[Tao Jaxx]

@JPC99 Because they expect the yield to become negativer lol. So they expect the bond price to rise.
Simple as that.

[Salmo trutta]

Re: "Long-term yields rose during periods of QE and always fell when QE ended"

QE induces nonbank disintermediation. I.e., the FED's technical staff is running the economy in reverse. Banks are black holes. If savings are “lent” (shifted from derivative deposits), to another commercial bank, there is no change (from a system's perspective), in the volume of deposits, no change in the volume of assets, nor any change in the volume of excess reserves. The only thing that has taken place is the passive or negative change of total inactivity of the deposits.

[Salmo trutta]

@Salmo trutta QE is a Romulan cloaking device. If you swap duration for cash you destroy velocity. Contrary forces are at work. The supply of loan funds is reduced while the demand for loan funds is also reduced.

[blenkep]

Could you cite your source to establish government bonds have returned more than 3.5 times the S&P since 1980. There is no way that is true.

[Tao Jaxx]

@blenkep That's not what I find here:

pages.stern.nyu.edu/...
This adds up to a dollar invested in stocks since 1985 having a total return of $50.14 vs. $11.80 in bonds.
Levered bonds can be an attractive diversification option though.

[RandyFloyd]

@blenkep i ran it on portfoliovisualizer.com. using 1980 as the starting point, long term gov bonds made 8.91% annually, whereas "total stock market" made 11.84%, amounting to about triple what the bonds made. i have no idea what the author is referring to

[Gio Danisi]

@Tao Jaxx
However the author said: 1980, not 1985. I did my own roughly calculations and 1$ invested in 30 years treasuries in 1980 (and reinvested in another long term treasury at the expiration) would amount to 40$ today, while the same dollar invested on spy would be more than $100 today. I could be wrong by 5-10 percent here and there but anyway...can't get even closer to the number cited in the article.

[user061]

U.S. bond yields were low in 2014 because growth and inflation expectations were low at the time. The situation is much different today. With core PCE at 4.1% today vs. a peak of 1.77% in 2014 and a Fed newly determined to control inflation, one has to consider not only a much faster tapering but interest rate hikes ensuing if inflation persists next Spring. Moreover, monetary policies are tightening around the world that could impact demand from international buyers.

[Patrick Doyle]

@user061 I don't think The Fed controls the entire term structure. They set the overnight rate, and that's it. The idea that they can raise or lower interest rates is one of the more bizarre byproducts given to us by the financial media....another being that the Fed "prints money."
The fact remains that they tapered, everybody assumed yields would rise, and then yields fell at most maturities....it's as if the bond market didn't believe them.
Also, check out the muted reaction to Powell's Nov 4 announcement about future tapering....long dated treasuries are higher (!)

[user061]

@Patrick Doyle Of course, I understand how the Fed operates. It's better for me if there are different views in the market.

[Patrick Doyle]

@user061 ...Okay then.

[Andrew G. White, CFA]

Interesting article, Danielle. Please forgive my naiveté, but will you please provide data/link for the assertion that the total return of bonds has been 3.5x the total return of the S&P500 since 1980? The total return of the S&P500 since 1980 has been 11.8%. Thank you.

[NBR Market Monitor Monitor]

Jut how much lower can yields go to increase the value of bonds any further?
Right now bonds are a trap for widows and orphans that have financial advisers that don't care or are not paying attention or worse yet make their money steering people into bonds.

[Patrick Doyle]

@NBR Market Monitor Monitor
Some simple math gets at your question. TLT (ETF of 20+ Year Tbonds) pay ~$2.21 and are currently priced to yield ~1.45%, and is trading at ~$153 pre market. If yields drop to 1%, the price rises to ~$221 for a 44% return.
If yield drops to 1.25%, then $177, etc.

These are better on a risk adjusted basis in my opinion than buying some more (expletive deleted) Amazon or Tesla or Netflix.

[blenkep]

@Patrick Doyle what if the yield rises to 2.5%? There are more investment choices thanTLT or Amazon.

[Patrick Doyle]

@blenkep I strongly agree that there are alternatives....I like uranium, for example.
In my view, the balance of probabilities favours a drop in the yield. Monetary conditions are tight, the economy's not particularly strong, banks aren't willing to lend much at the moment...For that reason I own calls on TLT.
If I'm wrong and my calls get wiped out, and yields rise to 2.5%, I'll probably buy treasuries.