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An Analysis Of The Risk/Reward Balance For Intermediate And Long Term Treasuries

There are a number of recent SA articles where the author argues that investors need to buy U.S. treasuries, giving a variety of reasons without in my opinion adequately discussing the risks.

One SA author attempts to make a case for a "trading shift from stocks to treasuries".

Another pounds the table for longer term treasuries, arguing that investors need to ignore their paltry yields and to focus on their scarcity value that may propel further capital appreciation.

Another author points out the benefits of low cost treasury and a total bond index ETFs as portfolio stabilizers and shock absorbers when stocks tank, which has recently been the case.

Treasuries were just about the only asset class that went up in value during the months following Lehman's collapse.

He further buttresses his argument for owning treasuries and other high quality bonds by showing the overall historical returns generated by having an allocation to both stocks and bonds that is periodically rebalanced according to a predefined formula. (There's Very Little Chance Of Beating A Balanced Portfolio From Here | Seeking Alpha)

I view that kind of historical analysis to be helpful, even though it is flawed at its core for the reasons discussed below.

The past is not necessarily prologue for the future. A 30 year treasury bond can not be bought at auction today with a 15%+ yield, which was the case in 1981. The yield was at 2.25% on 2/2/15. GE was not a good investment at $59.75, the closing price from 10/5/2000 simply because it had a good run from 8/15/1982 to 10/5/2000, generating a total annualized return of +26.76% during that period and a -2.71% annualized total return thereafter through 3/6/15.

The future is more important than the past.

And contrary to the assertions made by some here, a correct call that treasuries would rally in 2014 does not mean that the pundit is making a good call now.

Part of their analysis seems dependent on their views about stocks being overvalued using a variety of traditional valuation criteria such as the Shiller Cape P/E, the Q Ratio and Market Cap to GDP. All of the forgoing links are to Doug Short's website.

I have been arguing here at SA and in my blog for several years that there were long term and powerful forces underpinning a long term secular bull market in stocks. An example would be my comments to this bearish Seeking Alpha article published in February 2013. Low inflation and inflation expectations are important to that thesis. I am not going to address further those issues here, other than to note that my Vix Asset Allocation Model, which has a lot of street creed for me, is still flashing a green light for stocks.

Instead of arguing whether stocks or bonds are better at the moment, I will simply note that current stock market valuations are stretched IMHO, even with my optimistic view about the next 10 to 15 years.

I have also been surprised that the S & P 500 could almost double from the correction lows hit in 2011 without having at least a 10%+ dip. On 10/3/2011, the S & P 500 closed at 1,099.23.

A 10 to 15% correction typically happens once a year. It is extraordinary to have a near doubling of that major index with no correction for over 3 years. That is at least a clear affirmation of Peter Lynch's oft quoted remark: "Far more money has been lost by investors preparing for corrections, or trying to anticipate corrections, than has been lost in corrections themselves," quoted at CBS News.

The distinct possibility that stocks may correct, at some point, does not mean that I would sell stocks now to buy the Ishares 20+ Year Treasury Bond ETF (NYSEARCA:TLT) or the riskier Pimco 25+ Year Zero Coupon U.S. Treasury ETF (NYSEARCA:ZROZ).

The odds of jumping from the frying pan into a fire are not insignificant.

I will first discuss bond and bond fund duration risk.

Duration: Interest Rate Risk

What happens to a bond fund's value when interest rates rise? As we all know, a bond's value will move inversely to interest rates. A rise in interest rates will cause the value of a bond to go down in value, assuming no change in the credit risk component of the bond's pricing.

There was last Friday (3/6/15) a minor increase in rates with the 30 treasury rising from a historically low 2.71% to a less abnormally low yield of 2.83%.

Daily Treasury Yield Curve Rates

TLT declined by 2.21% last Friday, or close to the total dividend payments for an entire year.

PIMCO's treasury strip long treasury ETF, which has no coupon payments, declined 3.81%. That long duration ETF closed at $138.65 on 2/2/15 and at $116.4 last Friday or about a 16.05% decline in a little over a month.

I am not off base in describing last Friday's interest rate rise as a movement from one abnormally low yield by modern historical standards to a slightly less abnormally low yield. An all time low in the 30 year treasury was hit at 2.25% just a few weeks ago.

The data for this chart starts in 1977:

30-Year Treasury Constant Maturity Rate-St. Louis Fed

The 10 year treasury yield data goes back to 1962:

10-Year Treasury Constant Maturity Rate-St. Louis Fed

I am not sure why investors would want to play these securities for more capital appreciation, but that is up to each investor to decide. With an event like the Great Depression happening again, a 1% to 2% 10 year treasury yield would be understandable, and there are many who believe for reasons that are incomprehensible that the current worldwide economy is similar to what happened in the 1930s.

I just look at it from a risk/reward perspective and see more potential risks than rewards.

I am not willing to project the present and the recent past into the future without evaluating likely future scenarios and assigning possibilities to their outcomes.

To assess the risks, the first thing to comprehend fully is interest rate risk.

A bond fund investor needs to know their fund's "duration". The duration will provide a rough estimate of the fund's sensitivity to changes in rates. The general rule of thumb, as explained in the following citations, is to multiply the duration by the percentage change in rates:

Duration-What an Interest Rate Hike Could Do to Your Bond Portfolio - FINRA

Get to know your bond fund: Duration | Vanguard

For example, the duration of TLT was 17.74 years as of 3/5/15, according to the sponsor. A 1% rise in rates at that duration level would cause an approximate 17.74% loss in value, while a 2% rise in rates would generate an approximate 35.38% loss. The sponsor states that the 30 day SEC yield at last Thursday's closing price was 2.5%.

It only requires common sense to see the risk/reward balance in those numbers. There is a ton of downside risk in exchange for the "rewards" of a paltry yield and the prospects of further capital appreciation.

A return to an average 10 or 30 year treasury yield would inflict carnage on the owners of TLT. The average 10 year yield is close to 6% since the bond bull market started in 1982. The average since 1912 through 2014 is 6.34%. The losses generated by a ten year treasury yield near 4% would be huge.

Situational Risks-Low Yield Bond Investing:

One of the most profound risks is that a household will have insufficient funds to meet reasonable retirement expenses and other extraordinary expenses during their working years including a child's education, medical costs, financial support for aging parents, and other major expenses.

Is the investment plan going to increase sufficiently to meet those needs?

For most Americans, the answer is no.

I base that answer on a variety of data including the September 2014 Federal Reserve survey of consumer finances.

It is certainly not going to happen for most households by investing in bonds that pay 2% or 3% in interest.

Before taxes and inflation, a 2.5% compounded return takes 28.07 years to double Estimate Compound Interest. If inflation averages just 2.5% per year, the real rate of return before taxes would be zero. The long term historical inflation rate in the U.S. is 3.74% from 1957 through 2014.

This is not an argument that credit "risk free" savings have no place in an investor's portfolio. It is an argument against over weighting that kind of investment now.

Risk of Lost Opportunity:

This risk is related to interest rate risk. If I have money tied up in a bond with a current paltry yield, and interest rates start to go up, I have two unsatisfactory options. I could sell the bond and then redeploy the funds at a higher rate or lose the opportunity to generate more income with a higher yielding bond by holding onto the lower yielding one, even though it is depreciating in value.

The Deflation Hysteria:

Over the past year, a number of bond fund managers have stoked investors concerns about deflation and economic stagnation enveloping the U.S. until the end of days or close to it. The fact that this dire economic forecast plays into their book and to their financial advantage apparently does not call into question the rationale and factual basis for the forecast.

It is interesting that this Japan Scenario thesis has gained considerable weight in investor land without the U.S. actually having more than one calendar year of deflation since 1955, and that was an understandable -.4% in 2009.

The following snapshot shows the recent annual U.S. CPI numbers:

Sourced: Consumer Price Index, 1913- | Federal Reserve Bank of Minneapolis

And before anyone starts to hyperventilate about the inevitability of the Japan Scenario, the following are long term nominal GDP and CPI charts for the U.S.:

Consumer Price Index for All Urban Consumers: All Items-St. Louis Fed

Gross Domestic Product-St. Louis Fed

The Real GDP numbers, adjusted for inflation, will be lower due to the ongoing and prolonged U.S. inflation history. Real Gross Domestic Product-St. Louis Fed

The ten year treasury was higher in the early 1960 when the inflation was lower than shown above:

CPI Table:

I mention that kind of historical point to raise a question. Normally, investors would demand at least a 2% spread to the average inflation rate for a ten year treasury note. Is today's price the "new normal", where ten year treasury real yields have vacillated from negative to slightly positive?

Or is the past 200 or so years of historical pricing at a much larger spread to inflation and inflation expectations the true and only normal?

The difference between the past and the present is the Federal Reserve's massive interference with the market's normal rate setting process. Inflation has been trending higher over the past several years than the trendline from the 1950s and early 1960s.

Factors to Drive Rates Higher:

As the nation moves closer to full employment, the bargaining power will slide from employers to employees. This process has already started with the unemployment falling to 5.5% based on the government's last report. Employment Situation Summary

I read a story recently in the WSJ titled "Wages Rise at Restaurants as Labor Market Tightens".

I am not one who believes that Wal-Mart decided to raise wages out of some Christian desire to do good works. Hourly pay will rise to $9 per hour for associates starting this April and to $10 next year. It was a decision made to preempt as much as possible widespread employee defections as better paying jobs open up for them.

"Wal-Mart boosts pay of its low wage workers: Is inflation just around the corner?" | Brookings Institution

In June 2015, the Gap will raise its hourly rate for 65,000 employees to $10 per hour from $9. This is not an isolated trend.

Obama raised last year the minimum wage for federal contract workers to $10.1 per hour. NPRM Executive Order 13658, Establishing a Minimum Wage for Contractors - Fact Sheet - U.S. Department of Labor

Overlooked by the Deflationists, the annual CPI report showed a number of categories evidencing inflationary pressures:

On a non-seasonally adjusted annual basis for the U.S., food prices last year rose 3.4%; the cost of shelter increased 2.9%; the rent index rose 3.4%; the medical care index accelerated at 3% and the food category that includes meat, poultry, fish and eggs rose 9.2% (veal and beef rose 18.7%). The BLS called the rise in food prices "a substantial increase" over the 1.1% rate for 2013.

Consumer Price Index Summary

Healthcare costs, as a percentage of total consumer spending, hit 20.6% in 2014, yet another all time high. I do not recall a year when medical cost inflation was less than 2%.

With the exception of the past few years, the long term trend has been for 4%+ annualized healthcare cost inflation. Medical and college costs have traditionally increased at far faster rates than the overall CPI index.

I would note that the Cleveland Fed's median CPI was up 2.2% over the past 12 months through February 2015.

And how does the deflation and economic stagnation forecast fit into the recent economic data?

Is that dire long term U.S. inflation and growth forecasts embedded in the current historically abnormal yields justified by the 5% real Gross Domestic Product growth in the 3rd quarter perhaps slowing to 2.0% to 2.5% (partly based on a drawdown in inventories) in the 2014 4th quarter with personal consumption expenditures accelerating; the lowest readings on record in the debt service payments to disposable income ratio (DSR); household debt to GDP declining from 98+% in early 2009 to 80% in the 2014 third quarter; the S&P/Experian Consumer Credit Default Composite Index near a five year low; the decline in the unemployment rate to 5.7% with 257,000 jobs added in January with a 12 cent rise in average hourly earnings and a 147,000 upward revision for the prior two months; the decline in the unemployment rate to 5.5% in February with 295,000 new jobs; a decline in the 4-week moving of initial unemployment claims to the historical lows over the past four decades; the long term forecasts of benign inflation as reflected in the break-even spreads for the 5, 7, 10, 20 and 30 year TIPs; a temporary decline in inflation caused by a precipitous drop in a commodity's price; the consistent and long term movement in the ISM PMI indexes in expansion territory; capacity utilization returning to its long term average where business investment has traditionally increased by 8%, the ATA's Truck Tonnage Index hitting an all time high in January, or perhaps some other "negative" data set.

I am starting to wonder whether the advocacy of the deflation/stagnation scenario until the end of days is a psychological phenomenon that afflicts primarily the usual doom and gloom crowd, gold bugs, perpetual pessimists who will grab hold of any negative data point and blow it out of proportion to justify their innate tendencies, and those who became stock bulls just in time for the 50% or so declines in 2000-2002 and 2008. There are certainly many in the investment community who will make tons of money selling the "new normal" to those investors.

While it is just an opinion, I do not believe that the Bond Ghouls have adequately considered the impact on demand resulting from a few hundred million souls becoming middle class consumers in the developing world.

Factors to Drive Rates Lower:

CPI was driven into negative territory in the 2014 4th quarter and earlier this year by the 50%+ worldwide decline in crude oil prices. Natural gas prices have also fallen. It is anyone's guess at the moment when supply and demand will come into balance and cause prices to accelerate. This significant contributor to recent low inflation numbers could easily flip to be a major cause of inflationary pressures. I would not count on the WTI crude price remaining below $60 for more than a year.

Even lower sovereign yields in Europe make the U.S. treasuries look attractive to some buyers. I wonder though how a thirty year German bund with a 0.98% yield, the closing yield from last Friday, will look to a buyer at that yield in a year or so. The average inflation rate in Germany has been 2.45% since 1950 through 2014. And, notwithstanding all of the deflation chatter, that nation has yet to post an annual deflation number in modern times even with that 50%+ decline in crude last year. Historic inflation Germany It would not take much inflation to turn that .98% thirty year bond into a continuous negative real yield security.

I understand that many will say that the U.S. treasury rates are justified given the negative yields on the 2 and 5 year German notes and the .98% yield on the German 30 year long bond. One nutty price does not justify another. I was certainly not arguing that GE was worth $59 in 2000, or that KO was fairly valued at $42 in 1998, simply because Cisco was selling at $70 in 2000, or somewhere over 100 times something called "pro forma" F/Y 2000 earnings (and would report a $1.014B GAAP loss in F/Y 2001)

There has been a mismatch between supply and demand of U.S. treasuries caused by the Federal Reserve. Before the FED ended its latest buying spree, the U.S. government had bought up more than 50% of most U.S. treasuries notes and bonds maturing in 10 years or more.

As of 3/4/2015, the Federal reserve owned $2,346,706,071.1 in U.S. treasury notes and bonds, and $98,468,910.3 of U.S. TIPs. System Open Market Account Holdings -Federal Reserve Bank of New York I am glad the treasury is keeping good track of those numbers to the 10 cent range when the owned debt is in the trillions.

The federal government continues to add to its debt, closing in on $18.2 trillion as of 3/5/15. Billions of new issues are being auctioned to finance new debt and to pay off maturing issues with the Fed now on the sidelines. So, the supply is increasing.

The massive treasury hoard owned by the FED probably does impact prices by removing supply, but it remains to be seen for how much longer that restraint will be effective to tap down intermediate and longer term rates, particularly if inflation heats up later in the year.

The dollar's strength will tap down some on inflation. Currency movements have not been long lasting as reflected in this 10 year chart of the EUR/USD: EUR/USD Chart It is more like what goes around comes around.

A continuation of sluggish worldwide growth creates pockets of excess supply that restrains prices or causes prices to decline. I personally view the decline in crude prices to be more of an oversupply problem that has plagued producers for over a century.

The economic theory now being advanced by economists, generally known as Neo-Fisherites, postulates that the abnormal monetary policies of central banks (e.g. ZIRP, negative rates, QE, etc) are contributing to deflationary tendencies. That theory may turn out to be correct, at least when those policies continue for too long.

Stephen Williamson: New Monetarist Economics: Theories of Inflation and the European Predicament

For about three years or so now, I have also noted a study, summarized at The Big Picture blog and at Forbes, that predicted a slower than normal recovery due to those abnormal policies.

Volatility of Asset Correlations:

I do not dispute that bonds are important in an asset allocation plan. When I was younger, I viewed bonds as an alternative name for some kind of old person's disease. At some point, it dawned on me that the purchase of a 15% thirty year treasury bond in 1981 would have generated close to the same returns as stocks over the course of a long term secular bull market without all of the drama.

My brain was also rewired after listening to Frank Sinatra music; and the memories from the long term secular bear market in bonds started to fade as the distance in time expanded from that horrific period for bond investors. Consequently, I am now a bond and a stock investor.

I know that is hard for the youngsters here to fully comprehend, until you have been there and done that, but there is an animal known as a long term secular bear market in bonds. The last one started around 1950 and lasted until 1982, and the carnage is reflected in this chart of the 10-Year US Treasury note yield since 1790.

The damage to one's wealth caused by bonds started with a thousand paper cuts, with the coup de grace administered in the late 1970s and early 1980s.

Between January 1949 through December 1965, stocks were in a bull market that produced an annualized total return, adjusted for inflation, of +14.183%. S&P 500 Return Calculator

I do not have the real return for bonds during that entire period. I recently read an article that showed the annual real returns from ten year and long term treasuries as -1.27% and -2.12%, respectively, between 1950-1959. The total real return over that period were losses of 19.97%, 10.6% and 12.38% for long term treasuries, long term corporates and 10 year treasuries respectively.

In other words, bonds were a drag on total return during that long term bull market in stocks.

Financial planners have a tendency to rely on crutches, and one crutch is assume that asset correlations remain stable or can be predicted based on the recent past.

Asset correlations are volatile and dynamic. Treasuries may have positive and negative correlations with stocks, as shown in this chart at page 3 of this PIMCO Publication:"The Stock-Bond Correlation".

As to positive correlations, I divide history into two general trends. There will be occasions when stocks and bonds will have what I simply call "positive positive" correlation (both asset categories are going up) or "positive negative" correlation (both asset categories are going down). The first word defines the statistical correlation, whereas the second word summarizes the directional move for a long only investor.

It is also possible for bonds and stocks to be negatively correlated. Stocks may be going up with bonds going down (1950-1965 trend), or bonds could be going up with stocks going down.

When both asset categories have been in a long term secular bear market (1966 to 1982), conditions may be ripe for both to move mostly in a "positive positive" long term correlation.

Similarly, conditions may exist in the future where both move in a positive negative correlation based on a past long term and robust move up in price, and in the context of the then current and future economic conditions.

At the moment, my current thinking is that bonds will be a drag on total performance numbers over the next decade or so, while stocks will remain in a long term secular bull mode with the usual amount of drama, including numerous dips, corrections, and a cyclical bear market similar to what happen in October 1987. That opinion is subject to change and must be challenged in an unbiased manner continually as I gather and evaluate new evidence.

My parting thought in this section is just to emphasize, as I have in the past, that asset correlations are dynamic and volatile and current conditions need to be evaluated to determine likely positive and negative asset correlations going forward. (e.g. Stocks, Bonds & Politics: Instability & Volatility in Asset Correlations 2009 Post) Using past data to predict asset correlations, without thoroughly evaluating current and reasonably foreseeable economic conditions, will likely lead to erroneous results or possibly correct results due to random chance (sort of like splitting a pair of face cards playing blackjack and managing to win both hands).

Risk/Reward Balancing Act:

First, it is important to recognize that no one can actually predict the future with certainty, though some pretend to have God like powers. I will readily admit that I am not omniscient.

All that mere mortals can do is to collect the evidence, analyze it, form a non-biased judgment about the possible future scenarios and then assign probabilities to each one.

Given that uncertainty, I could justify holding some long term treasuries even after assigning a very low probability to the Japan Scenario for the U.S. and concluding that downside risk was far more pronounced than potential rewards. Why? I may be wrong about that assessment.

Second, I have arrived at an opinion, which is what I have to act upon, that treasury notes and bonds have too many risks and too few potential rewards at their current yields, unless the investor has good trading skills in that asset class.

I sold my last 10 year TIPs, bought at auction and owned in a Roth IRA, back in 2012 at a NEGATIVE CURRENT YIELD of -.89%:

Sold 3 TIP Bonds Maturing in 2019 at 120.45 (5/25/12 Post)

At the time, I characterized that price as the bond market equivalent of stock prices in 1999. Does that yield make any sense whatsoever? Bond investors had lost their marbles IMHO.

Instead of accepting the paltry treasury yields, I have bought and sold higher yielding bonds and preferred stocks including the various categories of exchange traded bonds.

Having been around for awhile, I have seen both stock and bond investors go off the deep end. Usually, it may take the Stock Jocks a year or two to recognize that they have gone nuts in a widespread delusional group think. The vision thing sort of goes haywire (e.g. late 1990s)

The Bond Ghouls, who view themselves as smarter than the Stock Jocks, have a vision problem too. I prefer to say "vision" rather than "delusion".

Back in the 1980s, when it was obvious to the Stock Jocks that problematic inflation was dying, the Bond Ghouls continued to price long term treasuries as if problematic inflation was still around and would remain a problem for 30 years. How else could one explain a 13.94% 30 year treasury yield in 1984 (5/31/84) when the inflation rate had already fallen into the low single digits (3.2% in 1984). The Stock Jocks had it figured out no later than mid-August 1982 and went into their long term secular bull mode dance.

The reason for the extremely long term secular bull market in bonds is that it took about 15 years for the Bond Ghouls to have enough confirmatory data to align their inflation forecasts with reality. As a consequence of their inflation forecasts being absurdly out of whack with what actually happened, the improperly priced bonds became more and more valuable as the tame CPI continued and produced substantial returns to those who bought them. Maybe our destitute Uncle Sam should ask for a refund.

A 14% thirty year treasury auctioned in 1984 had close to a 11% or so real rate of return through maturity. What will be the real rate of return for the buyer of the 2.25% 30 year treasury over the next thirty years? We know that it can not be 11% unless, I suppose, the current fad for negative interest rates gets really out of hand or 10% annualized deflation numbers come to pass.

In summary, it does not matter to me now whether the long term treasury goes up more in price and down in yield. Yes, that may happen. The issue for me is whether I now see the risk/reward balance as justifying a meaningful exposure to bonds with significant duration risk.

For me, the answer is no way. As an American citizen worried about the long term fiscal health of my government, I would like to express my profound and eternal gratitude to those willing to lend money to the U.S. government at negative real rates. I dread the day when the annual interest expense goes over $1 trillion dollars, which will be added to the debt, and is a larger sum than the U.S. total debt prior to 1980.

Lastly, corporate bonds are priced off the "risk free" treasury yields for similar maturities. If treasuries are being mispriced now, then all U.S. bonds are likewise being inappropriately priced by investors.

Disclaimer: I am not a financial advisor but simply an individual investor who has been managing my own money since I was a teenager. In this post, I am acting solely as a financial journalist focusing on my own investments. The information contained in this post is not intended to be a complete description or summary of all available data relevant to making an investment decision. Instead, I am merely expressing some of the reasons underlying the purchase or sell of securities. Nothing in this post is intended to constitute investment or legal advice or a recommendation to buy or to sell. All investors need to perform their own due diligence before making any financial decision which requires at a minimum reading original source material available at the SEC and elsewhere. Each investor needs to assess a potential investment taking into account their personal risk tolerances, goals and situational risks. I can only make that kind of assessment for myself and family members.