- First quarter was the worst on record for U.S government bonds.
- With the recent 8.5% CPI print, most think the 10-year at sub 3% is crazy. Even more so for the 30-year at a similar yield.
- A year or two ago, consensus could not even fathom $80 oil, despite the basic math on supply pointing to a shortfall, irrelevant of a war.
- In a similar fashion, the math points to lower yields ahead and it's being ignored. In the coming years, low inflation and even deflation are real possibilities.
- Regardless of whether or not we get low or no inflation, here's why today's rates are closer to a ceiling than a floor.
Quotes for the Dow Jones, S&P, Nasdaq, Gold, Crude Oil, and Bitcoin. That’s what you will see on the top left of Seeking Alpha’s homepage. The 10-year Treasury? Nope. Forget the German Bund, UK Gilt, or Japanese Government Bond.
Despite the fact that Bitcoin’s market cap is less than a trillion, while the global bond market is well over 100x larger, retail investors don't seem to care much about it.
Why? Well the reasons I hear today are no different than a decade or two ago. Things like "inflation is X% while bonds only pay Y%" and "the yield on XYZ stock is 5% while a 10 year bond only pays me 2%," and "even a low dividend yield goes up over time, while a bond yield does not." Stay tuned, I’ll provide rebuttals for all of these.
With the recent 8.5% CPI print (which we all know is grossly understated) this hating on bonds is louder than ever. Or at least, it feels comparable to the period after the Great Financial Crisis.
Back then, it wasn’t supply chains and the great resignation fears. Everyone was terrified all the money printing would cause runaway inflation. I too used to believe that, then over a period of a couple years, between 2010 and 2012, I finally got it and have been a bond bull ever since.
To be clear, that doesn’t mean my fixed income exposure is always the same weight. In January 2020, it was 37%. After the Covid crash, most of that was rotated in equities. During the latter half of 2021, my bond exposure down to a single digit percentage. In just the past month or so, I’ve now taken it back up beyond 25%.
After you read this, you will understand why now might be an opportune time to load up on long duration Treasuries, such as the iShares 20+ Year Treasury Bond ETF (NASDAQ:TLT).
People don’t buy things, they buy payments
Does the average American buy a house or a car? How about braces for their children's teeth? Or that new iPhone? Nope. Usually, they buy the monthly payments for these things. All people seem to care about is what something will cost them per month. Sad but true.
The reason why money printing didn’t cause the inflation everyone expected after 2008, and why the current fear of supply chain/war/great resignation causing the same won’t last forever, has to do with our house of cards built on debt.
In short, since 1980, continuously rising debt – not rising incomes – is what has made our desired standard of living possible. Not just in the United States. The same apples to most developed nations.
A great chart depicting this was published a few days ago by Lance Roberts on Seeking Alpha:
Since around 1990, the gap between real disposable incomes (DPI) and cost of living went negative. You can see how debt has been filling that gap since.
It is estimated that today, each household requires an extra $6,400 of new debt per year just to maintain our current standard of living.
How do we keep this party going? We have two options:
- Decrease our standard of living dramatically and live within our means.
- Increase debt but in order to afford the servicing costs, we will need lower rates.
Being that we are pain-adverse woke Westerners, which option do you think we will choose?
Not the first.
Obviously this is not sustainable forever. Eventually, we will come to a point of needing a reset of some sort. The pain of the great financial crisis will feel mild in comparison. For that reason, you can bet we will postpone the inevitable as long as we possibly can.
Perhaps I’m wrong but personally, I believe we are still a ways off. Why? Because we’re relatively early in the Japanification of rates. Our low rates can go lower, even negative.
Since Volcker, each hiking cycle has been smaller than the last
Will we get 50 bps at the May and June meetings? Probably. However, I will be shocked if the FFR exceeds 2% during this cycle. This premise is based on simple math which contrary to consensus, has only minimal correlation with inflation.
Since Volcker, each hiking cycle has averaged roughly two-thirds the size of the prior. Each time, there's more debt to service and hence, rates can only go so high. My friend Mish Shedlock published a great chart showing this and how the market priced treasuries in comparison:
With the exception of Volcker, you can go back over 50 years and see that once the fed funds rate has exceeded the five year treasury yield, there has never been a subsequent hike.
We should hit that point before the end of 2022. Possibly even in the 3rd quarter. Once that occurs, it will be difficult to keep hiking. Yes, the dot plot shows hikes through 2023 but can you name one time ever in which the dot plot as come to fruition?
Lastly, I’ll present to you the "hairy caterpillar" chart, which compares fed expectations versus what the fed actually delivers. This comes from Roberto Perli at Piper Sandler:
Market expectations have always been wrong. Should you really expect any different this time?
They say don’t fight the Fed, which is true. However I think a better tagline would be:
Always count on the Fed to overpromise and underdeliver.
Please take both into consideration.
Negative Q1 GDP print may be just the start
I wasn't expecting a negative print until Q2 of this year, so to get it in Q1 even surprised me a bit. Sure, it might get revised upward but that doesn’t change its message; the economy is weak.
After stimulating ourselves with some $10 trillion on COVID, the writing was on the wall that we would be in for a bad hangover.
The war only exasperates that by blowing our budgets further. It’s not just energy. Did you know Ukraine produces one-fifth of the world’s high-grade wheat? Heck, that’s even what their flag represents; blue skies above with golden wheat fields below.
Now without our stimmies, PPP loans, meme stocks, and the crypto casino to fill holes in our budget, do you really think we can afford 8 to 9+ hikes on the FFR? Remember we buy payments, not things. Can we really afford higher payments right now?
Even without rates going up, the principal on those payments is already climbing because of inflation. This is also why, eventually, the great resignation may become a thing of the past. What made giving the middle finger to the boss possible was the $10 trillion sugar high we were on. Not anymore.
Fortunately, the upcoming need for real jobs (vs. living on handouts and speculative endeavors) should help ease the inflationary pressures coming from today’s labor shortage.
Why buy bonds yielding 3% when there's 8% inflation?
This is how most people think. They’re thinking about the yield on the bond and then comparing it to something else, whether that be inflation or the yield on an equity. Everything looks better in comparison.
Well, you’re not buying a bond primarily for the yield. That’s just icing on the cake.
You buy (or sell) bonds based on the direction you believe yields are heading.
Let’s say you put $1,000 into a 30 year treasury when its yield is 3%. Then one year later, the yield on the 30 year falls to 2%. That means your treasury will be worth 29% more; $1,290 (29 years left multiplied by the 1% rate drop).
Of course this goes both ways. When rates rise, your bond values fall. That’s what we’ve experienced year to date. In fact it was the worst quarter for U.S. government bonds in 40 years. Possibly longer, as record keeping only began in 1973.
Could this get worse? Absolutely. But if you’re a contrarian, you may want to consider the other side of the bet. Yes, it’s going against momentum and consensus, but contrarians do that anyway.
What about the fact that dividends generally go up over time while the yield on a bond is fixed?
Let’s compare the total returns of the S&P 500 vs. Treasury STRIPS, which are also known as zero-coupon. STRIPS is an acronym for Separate Trading of Registered Interest and Principal of Securities. They pay no coupon/interest. Instead they are sold for a discount to face value and when they mature, the payout is at par.
In short, they are the most aggressive form of treasury investing, because you are forgoing interest payments and therefore, not taking any chips off the table until maturity.
Yes, this chart is outdated by a couple years. The first STRIPS mutual fund didn’t come about until 2007, which was Vanguard Extended Duration Treasury Index Fund (VEDTX). ETFs came even later. For that reason, there isn’t an easy way to generate a real time chart comparing STRIPS versus the S&P or another index. The recent bloodbath in bonds does change the numbers in favor of stocks but only by a miniscule amount. Even after the worst quarter in bond history, the comparison isn't close.
Contrary to popular belief, the most aggressive form of bond investing has beaten the S&P 500 by several-fold these past few decades.
Now there are two very different takeaways one can have from this data:
- The A camp: The four-decade bull run in bonds is finally over. The chart moving forward will be the inverse.
- The B camp: The four-decade bull run in bonds is not quite over. It may be close, but 2.8% on the 10-year and 2.9% on the 30-year is still far above 0% and negative rates.
Based on what we’ve seen in Japan and Europe, I personally believe we still have plenty of room to go lower. Of course I could be wrong. This ultimately is a decision one must make after extensive research. I was in the A camp for years and as mentioned, it wasn’t until shortly after the Great Financial Crisis when I switched. There are persuasive arguments to be made for both sides. However I think if you analyze our aging demographics and replacement fertility rates ex-Africa, then factor in debt, you realize this decade and beyond will be quite different than those prior.
Treasuries, munis, or both?
You noticed I didn’t mention corporates. For me, bonds are a safety trade. The safest corporate bonds just don’t pay enough vs. treasuries and munis.
If you are in the B camp, treasuries offer some unique advantages.
The U.S. dollar is the world’s primary reserve currency. About 59% of all foreign central bank reserves are in USD. Makes sense, given that so many commodities are traded in USD, as well as trade in general. Furthermore, because there is so much global debt denominated in USD, there is constant demand by these debtors for USD, which they must use for debt payments. Lastly, there's the advantage of Uncle Sam having a printing press, so technically he can’t go bankrupt.
The iShares 20+ Year Treasury Bond ETF I mentioned at the start is the most well-known and liquid way to trade long duration treasuries. With nearly $20 billion of assets, it’s by far the largest ETF in the category. The TLT moniker is nearly as famous as "the Qs" from Invesco (QQQ). Perhaps that’s why BlackRock (BLK) can still get away with charging a 0.15% expense ratio, which is excessive by today’s standards. TLT is down 19% YTD.
TLT’s effective duration is about 18 years, though the weighted average maturity is 26. Since they are not STRIPS, you will collect yield. The 30 day SEC yield is 2.80%.
Is it my favorite? Definitely not. However in times of extreme turmoil – e.g. Great Financial Crisis and March 2020 – the liquidity offered is unmatched. Traders appreciate the afterhours volume.
The above chart may look like that of a Cathie Wood ETF, but it's not. It's the Direxion Daily 20+ Year Treasury Bull 3X Shares ETF (TMF). It's 3x leveraged. When TLT is up 1% on the day, TMF should be 3%. Given the costs associated with leveraging (1% expense ratio), it's generally best suited for shorter periods. It will not produce 3x returns in the long run.
At about 5% the size of TLT, the Vanguard Extended Duration Treasury ETF (EDV) is an even more aggressive option, as it consists of Treasury STRIPS with maturities ranging from 20 to 30 years. The 0.05% expense ratio isn’t a ripoff. Both the effective duration and maturity is about 25 years.
Similar to EDV is the PIMCO 25+ Year Zero Coupon US Treasury Index ETF (ZROZ). It’s inferior at about 1/3rd the size and 3x the expense ratio (0.15%). Though it does seem to be more popular for trading and it’s the STRIPS ETF I hear brought up the most. Despite its small size, the daily volume is still $25M, compared to $39M for EDV.
Personally, most of my bond exposure is with munis. While the interest on treasuries is exempt from state income tax, only muni interest is exempt from federal. Munis for your home state are exempt from both federal and state.
Rather than muni ETFs, I prefer buying closed-end funds (CEFs) opportunistically. Unlike ETFs, CEFs will trade far below and occasionally above NAV. Most juice the returns by utilizing leverage in the neighborhood of 37-44%.
While I have been buying several these past few weeks, my largest purchase was for Eaton Vance Municipal Bond Fund (EIM). It’s one I’ve owned consistently but in varying weight for many years, as I love its portfolio which is A+ credit quality. Currently trading nearly 10% below NAV, the 5% yield is appetizing considering that the effective duration is only 7.2 years (most muni CEFs are 10+). It's down 20% YTD.
For my home state of California, several have been purchased including the Blackrock MuniHoldings California Quality Fund (MUC). The portfolio is AA- credit and you get a 5.5% yield. If you're in the highest tax bracket and a CA resident, the tax equivalent yield is 12%. Effective duration is only 7.2 years and currently it trades for over 9% below NAV.
Liquidating CEFs is tricky enough due to trading below NAV and even more so if you need to unload a large amount. For this reason, CEFs should be considered only for a long term holding. They’re not quasi-cash vehicles that you can liquidate anytime.
Ultimately for most investors, particularly those with less fixed income experience, sticking with treasury ETFs like TLT and EDV is the way to go. While munis are most advantageous for taxes, nothing compares to the safety of treasuries. When the fit hits the shan, the only thing you can rely on rallying are treasuries. Munis won’t necessarily correlate.
This article was written by
Analyst’s Disclosure: I/we have a beneficial long position in the shares of EIM, MUC, EDV, TMF either through stock ownership, options, or other derivatives. 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.
I am not a financial advisor. This article is general information and for entertainment purposes only. It should not be misconstrued as being investment advice. Please do you own due diligence regarding any security directly or indirectly mentioned in this article. You should also seek advice from a financial advisor before making any investment decisions.
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