Sunday, December 15, 2013

Why Only the Foolhardy Scorn Treasuries

In May, when the Federal Reserve first started talking about reducing its $85 billion monthly purchases of Treasuries and mortgage-backed securities, yields jumped, to 2.72 percent in early July from 1.64 percent on May 1 for the 10-year note, and to 3.68 percent from 2.83 percent for the 30-year bond.

Yields stabilized after Fed officials took note of the panic and said any withdrawal of stimulus spending would begin only when the economy was stronger. Although central bankers vigorously denied that the tapering of bond purchases signaled an impending rise in interest rates, investors didn’t believe them.

Many interest-rate forecasters have insisted that the three-decade decline in U.S. Treasury bond yields is over, and they may be right -- finally. Yields on the 10-year note and the 30-year bond remain close to the recent highs reached two years ago. Then again, the Treasury bears have been proclaiming the end of the bond rally since rates began to decline in 1981.

In those days, few people agreed with me that inflation -- still running at more than 10 percent -- was unwinding and that interest rates would fall. The consensus called for rates to remain high or even rise indefinitely. Yet when 30-year yields peaked at 15.21 percent in October 1981, I said that inflation was on the way out and that “we’re entering the bond rally of a lifetime.” Later, I forecast a drop to a 3 percent yield. Then, too, other forecasters thought I was crazy.

Most investors have a distinct anti-Treasury bond bias, and not just because they believe that serious inflation and leaping yields are inevitable. Stockholders hate these securities because they don’t understand them. But their quality as investments has been unquestioned, at least until recently, and their prices rose promptly in 2011 after Standard & Poor’s downgraded the U.S.’s credit rating. Treasuries and the forces that move yields are well-defined: Fed policy and inflation or deflation are among the few important determinants.

Stock prices, by contrast, are much more difficult to assess. They depend on innumerable variables, including the business cycle, conditions in a particular industry, legislation, the quality of company management, merger and acquisition possibilities, corporate accounting, pricing power and products.

Stockholders do understand that Treasuries typically rally under weak economic conditions, which are negative for stock prices, and they consider declining Treasury yields to be a bad sign. It was only individual investors’ extreme distaste for stocks after the 2009 rout that precipitated the rush into bond mutual funds that year. Moreover, brokers don’t want to recommend Treasuries because commissions on them are low, and investors can avoid commissions altogether by buying them directly from the Treasury.

Those who worry more about inflation than deflation also hate bonds, which tend to fall in price as inflation increases. People who work in finance on Wall Street also disdain Treasuries. I learned this many years ago when I worked at Merrill Lynch & Co. and White, Weld & Co. Investment bankers didn’t want me to accompany them on client visits if my forecast was for lower interest rates. They wanted projections of higher rates that would encourage corporate clients to issue bonds immediately instead of waiting for lower financing costs. A similar dynamic is at work today as investors and companies anticipate Fed tightening and higher interest rates.

Managers of bond funds are sober professionals who always worry about inflation, higher yields and subsequent losses of principal in their portfolio. But if yields fall, they don’t rejoice over bond appreciation; they worry about reinvesting their interest coupons and maturing bonds at lower yields.

This negative view of bonds, especially Treasuries, persists despite their vastly superior performance compared with stocks since the early 1980s. Starting then, a 25-year zero-coupon Treasury, rolled into another 25-year bond to maintain the maturity, beat the S&P 500, on a total return basis, by 5.3 times, even after the recent substantial bond selloff. And that’s despite the stock rally from 1982 to 2000.

I’ve never bought Treasuries for their yield. I only care that it is going down. I want Treasuries for the same reason that most of today’s stockholders want equities: appreciation.

I like the 30-year long bond because maturity matters to appreciation when rates decline. Thanks to compound interest, each percentage-point decline in interest rates increases the value of a 30-year bond more than it does a shorter maturity bond. If yields drop 1 percentage point -- say, to 3 percent from 4 percent -- the gain is 8.6 percent on a 10-year note, but it is 19.7 percent on a 30-year bond. That said, the losses are bigger on longer maturities if rates rise.

I prefer Treasury coupon and zero-coupon bonds above other securities for three reasons. First, they have gigantic liquidity, with hundreds of billions of dollars trading each day, which means that only the largest investors can buy or sell without disturbing the market.

Second, in most cases, they can’t be called before maturity. Issuers of corporate and municipal debt can call their bonds at fixed prices, meaning appreciation is limited when interest rates are declining and you’d like longer maturities. Even if the bonds aren’t called, the threat that they could be often restricts their ability to rise over the call price. But when rates rise and you prefer shorter maturities, you’re stuck with the bonds until maturity.

And third, Treasuries -- despite the August 2011 S&P downgrade -- are still the best-quality issues in the world.

(Gary Shilling is a Bloomberg View columnist and president of A. Gary Shilling & Co. He is the author of “The Age of Deleveraging: Investment Strategies for a Decade of Slow Growth and Deflation.” This is the first in a two-part series.)