Tuesday, September 7, 2010

On the Value of Treasuries

In recent weeks, a number of investors I respect have commented that Treasuries are rich and should be avoided (or even outright shorted). Recent examples include Doug Kass and James Montier, both of whom claim current yields put too much weight on expectations of a double dip. I simply don't agree...

While I am not a Treasury bull, it is my view that at a 2.7% yield Treasury bonds are fairly valued when one takes into account the low growth / low inflation outlook, the Fed's extended easing policy, and the potential for capital appreciation rolling down the steep yield curve. Below we'll take a look at these three points in more detail.

Point #1) Nominal Growth Matters

This point was first shown in the following chart a few weeks ago.

In Doug's post he compares historical real GDP to Treasury yields and notes that bonds should be yielding more (he notes that Treasuries have historically yielded ~360 bps more than real GDP). The problem with this analysis outside of an apples (real GDP) to oranges (nominal Treasury yield) approach, is that a large portion of this "spread" was due to the inflation spike seen in the chart above during the late 1970's / early 1980's; a period marked by high nominal Treasury yields and low real GDP.

Point #2) The Importance of Monetary Easing Policy

A bond investor that does not take duration risk can only earn VERY low rates over the next few years as long as the Fed is on hold. If an investor earns VERY low rates for each of the next two years, they will need to earn a much higher return for the remaining 8 years just to break-even with the Treasury investment. The key is that the market is pricing this in.


Assuming a "zero" interest policy for two years (by zero, lets assume 0.25%), this means that a 2.7% yield can be achieved as follows:

  • The first 2 years at 0.25%
  • The last 8 years at 3.32%
The formula: (1 + 2.7%)^10 / (1 + .25%)^2 = 1.29878^(1/8) = 3.32%
The chart:

The relevance? The market is not forecasting rates will stay as low as they are now (i.e. forward rates are higher... closer to that 3.32% rate than 2.71%), which means capital losses will not happen simply if rates rise from current levels, but rather rise above levels expected by the market going forward.

Point #3) Don't Forget the Rolldown

The yield curve is VERY steep (i.e. upward sloping). This means that the 10 year bond will not only return its yield over the next 12 months if nothing changes (i.e. if the yield curve is exactly where it is today in 12 months), it will return more.

How much more?

Using current figures, the 10 year Treasury is yielding 2.71% while the 9 year Treasury is yielding 2.54% (17 bps difference). Assuming that nothing changes, performance of a 10 year bond over the next 12 months will be made up of the 2.71% yield plus the capital appreciation from moving from a required yield of 2.71% to 2.54% (i.e. a bond with a 2.71% coupon and a required yield of 2.54% will be worth more than par). This specific 17 bp move would add an additional 1.5% (assuming a duration of 8.75 years on a ten year Treasury) over the next 12 months, which means a 4.2% return for the 10 year note if nothing changes.

Source: Federal Reserve / BEA


Anonymous said...

This is the first time I've seen anyone but me mention the rolldown and steepness in print. Booyah.

Anonymous said...

You are assuming that rates will not move rapidly. This is a big assumption. Just look at how much the 30-year (mortgage) rates have moved in the last 3 years!

Jake said...

that is my assumption based on a slow recovery. if you disagree with that, you are better off going long stocks than short treasuries

Jake said...

bb- scare mongering (i.e. throwing out random #'s) gets you nowhere with me.

want a scenario where you lose 20% in 5 years?

here it is... with a coupon of 2.71%, the entire yield curve will need to rise 1000 bps (yes, 10%) for there to be a loss of 20% over 5 years.

possible? anything is, but extremely improbable (AND FAR FROM "EASILY"). in that type of environment you are likely better off investing in commodities and/or equities than shorting treasuries...

Jake said...

it looks like the bb post was removed by bb... to put my previous post in context, bb stated that treasuries will "easily" lose 20% of their value in 5 years

theyenguy said...

You remark: The yield curve is VERY steep (i.e. upward sloping). This means that the 10 year bond will not only return its yield over the next 12 months if nothing changes (i.e. if the yield curve is exactly where it is today in 12 months), it will return more.

On August 10, 2010, the 30-10 US Treasury Yield Curve started to flatten.

And it is likely to flatten even more, desperately more!

Therefore bonds will be yielding less, much less.

Many, coutless many in the press suggest corporate bonds; but I believe that risks run high by investing in corporate bonds.

My money has been going and will continue to go where I believe it will be the safest. I am not concerned about the return on my money; rather I am concerned about the return of my money. Therefore, I am invested in gold bullion which has no interest rate of return. I keep the gold well secured to prevent its loss.

Holding debt of any kind, even high grade corporate debt, exposes one to the risk of loss of principle as interest rates go higher. I believe that interest rates were called higher by the markets on September 1, 2010, in response to the US Federal Chairman Ben Bernanke announcing intentions to buy mortgage backed securities on not only one occasion but on two occasions.

High grade corporate debt, LQD, fell parabolically lower on September 1, 2010, with the purchase of the yen based carry trades, on September 1, 2010, which rallied stocks, ACWI; and turned the tide on bonds, BND, sending them lower, establishing August 31, 2010 as a high in bonds at 82.66, that is, ”establishing August 31, 2010 as peak credit” … bond deflation has been underway since September 1, 2010.

High grade corporate debt, LQD, peaked on September 1, 2010 at 112.58. It has the same wave structure as BND; so any comments about bonds, BND, apply directly to LQD as well.

Going over to MSN.com and sorting on the 3 year returns, LQD shows 7.57%, which is quite good; going all the way to the bottom are such things as Natural Gas and Financial Services, which is quite bad.

I believe that LQD’s returns will be influenced by a flattening of the 30-10 US Sovereign Debt Curve, and by CDS.

The interest rate on the 30 Year US Government bond, $TYX, rose strongly September 1, 2010.
And the interest rate on the US 10 Year Note, $TNX, also rose strongly September 1, 2010.

September 1, 2010 marks the transition from “the age of neoliberal Milton Friedman based credit liquidity” to “the age of the end of credit”; this also means ”the end of entitlements” and “the beginning of world-wide austerity”.

The 30-10 yield curve,$TYX:$TNX, began to flatten on August 11, 2010, reversing a trend that goes back to early 2000.

This signals risk aversion to sovereign debt. The flattening of the yield curve came as a result of the Federal Reserve Chairman's announcement of August 10, 2010 of the purchase of mortgage-backed securities. Then on August 27, 2010, the Federal Reserve Chairman stated the possibility of an even larger purchase of debt.

This caused the bond rally in US Treasuries, TLT, and Zeroes, ZROZ, HIgh Grade Corporate Bonds, LQD, that began April 6, 2010, to fail September 1, 2010, sending bond prices lower and interest rates higher.

The safe haven rally in debt, and the low-interest rates available to corporations, that began with the onset of the European Sovereign Debt Crisis is over, repeat over and done, through and finished. Investors see Mr Bernanke’s plans as monetization of debt; and have gone short US Treasuries, especially the longer out ones such as ZROZ.

I see a coming ”see-saw” exhaustion of fiat wealth with stocks, ACWI, and then bonds, BND, alternatively falling lower. There may be days when both fall lower. The chart of Bonds, BND, for September 7, 2010 shows three black crows, with a fall in value to a head and shoulders pattern at roughly 82.00 and then a rise to 82.44.

bb said...

i did not remove my post, it got deleted by either you or google.

i said that in 3-4-5 years time the great buy you are touting now could suddenly turn very sour.

2% rise in the nominal interest rates in 3 years (that is around 2013, not so impossible and improbable as you suggest) will bring on your 10 year treasury bond that has 7 more years to maturity over 15% principal loss if you want to liquidate. if you do not want to, you are stuck with 2.7% gain, which will likely be well below the inflation rate over the entire 10 year time frame.

my problem is that you are touting 2.7% as a great return (i personally would never put money in such an 'investment' that barely matches the inflation rate). and that leads me to be bigger issue with most 'investors' that seem to be running money: the absolute (or relative) return matters, the risk is of no concern.
rather than bid treasuries to 0%, look elsewhere for yield where the risk is not 10 times the return you are being offered, even 3 year greek bonds are a better buy today.

bb said...


do you really believe we are going to get austerity the world over? the easiest thing to do is print money. hyper inflation is not highly probable since most of the world is already choking on the debt happy meal we were eating for so many years. now almost all income goes to liquidate debt, there the return is 3-4 times or higher than on 10 year treasury bonds (saving 8% interest expense vs. earning 2.7% in interest income taxed at 30%).

we are clearly still witnessing high inflation (5% or above depending on where you live) on all goods that you can buy with cash and price deflation of all goods that you usually buy on credit.

Jake said...

Bb- may have been my fault (my bad). Anyhow, find anywhere in my post where I say I like Treasuries. You can't. All that I say is they appear (to me) to be fairly valued (in fact i said I said I am not a Treasury bull) and I provided 3 points that are typically overlooked. You said they can easily lose 20%, which I countered.

Jake said...

"My money has been going and will continue to go where I believe it will be the safest. I am not concerned about the return on my money; rather I am concerned about the return of my money. Therefore, I am invested in gold bullion which has no interest rate of return. I keep the gold well secured to prevent its loss."

I actually like gold (I've posted why multiple times), but a speculative metal makes absolutely no sense for a pure preservation of capital argument.

Kersch said...

The formula you show near the top is incorrect.

Should be

(1+2.7%)^10 / (1+0.25%)^2 = etc

Jake said...

I wrote the wrong formula, but used the right one. Will fix...

Kersch said...

Yes, sorry. I didn't mean to imply the answer was incorrect. 3.32% is the correct answer.

bb said...

i think i already made myself clear, if not, here it is said in straight english: 2.7% may look like a decent return at present relative to other options, but the 10 year holding period simply locks your money till maturity in treasury bonds. otherwise, if you want to cash out earlier in 3-5-7 years time, you will have to take a double digit hit on your principal redemption.

the option to NOT seek higher yield than 2.7% for a 10 year period makes long maturity bonds quite unattractive. do you recall that most state/gov't pension plans have implied annual returns around 8? 50% difference is quite a shortage for 10 years, isn't it?

of course, money managers live under pressure to deliver higher returns by month/year end and they bid prices up without thinking where their 5-10 years returns will be, because anyways they will be with another employer. just like in politics, so in money management, your long term investment objective terribly misaligns with the short term objective of your agent.

and another more philosophical take on the gov't bonds subject: does a ponzi scheme qualify as an investment? isn't gov't debt that is rolled over and the interest is paid by more debt a classic ponzi scheme? according to minski's definition it is. but better not call things with their real names ;)

bb said...

and in the meantime gov't bonds could and shall continue to rally because the Fed is buying them, because the gov't employee pension planse are stuffed with them, bacause this is where asians and arabs recycle usd. supply and demand determine the price, value is an abstract and highly subjective definition.
will the afore mentioned groups ever see their money back? highly unlikely at the present purchasing power.

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