Thursday, July 7, 2016

Global Bonds are a Speculative Investment / The Case for Bond Speculation

Back in 2010 I had a post titled On the Value of Treasuries, where I outlined the total return for Treasuries was potentially greater than the (at the time) 2.71% yield given the very steep curve. The summary was that if the yield curve didn't change over a one year horizon, the total return for an investor was closer to 4.2% (the 2.7% yield plus and additional 1.5% coming from the ten year Treasury rolling down from a 2.71% yield to the 2.54% yield of a nine year Treasury). Not a bad trade at that time.

A Whole New World

Fast forward to today and you have a very different situation. Not only is the yield on the current ten year Treasury about half that 2.7% yield (1.39% as of yesterday), but the yield curve is very flat (the nine year Treasury yield is only 4 bps lower (1.35% as of yesterday) as the back-end has been smushed (a technical term).

As a result, the roll down math (assuming the yield curve does not change) is as follows:

Current yield + change in yield x duration = 1.39% + 4 bps x ~9 years = 1.75% total return

The Resulting Risk / Reward Profile for Treasuries is Horrific

As I'll outline with some simple bond math, a lower yield and a limited roll benefit makes the case for Treasuries much more speculative in nature... either speculative that rates in the United States will continue to move towards or through 0% (we've seen it in places such as Japan, Germany, and Switzerland) or speculative that cash will continue to yield less than the current 1.39% for years to come.

What we do know with certainty is that bonds will provide a nominal return roughly equal to their yield over a period of time roughly equal to their duration. In the case of Treasuries, that means with certainty Treasuries will provide a cumulative return close to:
  • 10 Year Treasury: (1 + 1.39%)^9-1 = 13.2% over the next 9 years
  • 30 Year Treasury: (1 + 2.15%)^22-1 = 59.7% over the next 22 years 
That doesn't mean Treasuries won't provide an outsized return over the next year, but any return in excess of its yield is like squeezing blood out of a turnip limiting its future return potential. The chart below outlines the potential returns for the ten year Treasury following various levels of 12-month performance. This short-term return could, in theory, be 15%, but that would just mean forward returns for the remainder of the duration will be negative (again... the cumulative return cannot move away from that 13.2% figure).

The Risk / Reward Profile for Global Bonds are Even Worse

Japanese Government Bonds (JGBs) show how much juice has already been squeezed out of some global bonds. There is a 40 year JGB that started 2016 yielding 1.42%, which now yields just 0.08%. The below chart uses the same framework as the chart above, but for the 40 year JGB at the start the year.

The result is a monster 50% return year-to-date (even more in US dollar terms given the yen rally), but this comes not at the expense of most of the returns for the next 29 years... ALL of the return for the next 29 years. In other words, to invest in 40 year JGBs effectively yielding 0% you are speculating that yields will move further negative or that cash rates will remain negative (on average) for a period that may be close to (or longer than) the rest of your life.

The Case for Speculation / Low Rates May Be a Self-Fulfilling Prophecy

All of that said, the challenge in this current market is that while the risk / reward profile of global bonds is horrific, speculation of even lower rates may turn out to be self-fulfilling if ZIRP is not partnered with increased fiscal spending.

Why? Because the juice has effectively already been squeezed out of the turnip, meaning future returns in global bonds are gone. This "should" have provided a bump to the global economy and global inflation by taking all the returns (and consumption) and pulling it forward, but it has not.

Why? Perhaps these gains have accrued to institutions that own these bonds (central banks, insurance companies, pensions, etc...) that won't spend it / are already on the hook for liabilities in excess of their assets, while investors who already lack the belief forward stock returns will be near the 8-10% they have historically provided, now project their future interest income from their cash or bonds to be at or below 0%.

The result is the need for individuals to save MORE, not less, for retirement, for a house, for a car. With no institution (corporate, government, etc...) willing to spend this increased savings in the form of investment (which seems like a smart thing to do as the hurdle for a positive NPV project is effectively 0%), deflation becomes a much larger possibility... in turn creating the possibility of even lower rates.