You do have choices, and could opt to invest your hard earned investment dollars into this bull market; Treasuries pay income, have a tremendous performance record, and are backed by the full faith and credit of our country. Moreover, all Treasuries have a market value of over $14 trillion, offering even more liquidity than the S&P 500 index at slightly over $10 trillion. But, should you?
Bottom line: Always hold some Treasuries as a hedge against a sluggish economy and deflation. But, don't chase them now, despite being in one of the greatest bull markets ever. Here are eight reasons why:
1. Interest Rates Are Close to 60 Year Lows
The interest rate on the 10 year Treasury, the benchmark maturity, has plunged to levels not seen since World War II, as low as 1.9%. The long term average has been 6.77%. If rates rise, you'ill be hurt badly: Expect a potential loss of principal value of about 8.4% % for each 1% tick up in interest rates.
While you could profit if rates fall further, further declines seem unlikely. Rates on the ten year have never been below 2% save for this year, a brief period in 2008 and just before World War II.
2. Many Treasury Buyers Are Simply Fleeing Other Asset Classes, and Will Exit When Conditions Improve
Burned by the 2008 financial crisis, wary of a sluggish economy, and nervous about Europe, investors have soured on equities and residential real estate. Mutual fund investors have yanked billions out of stock funds this year, while real estate prices remain nearly 30% below their 2006 peak.
Some investors have turned to Treasuries in this uncertainty. They've been richly rewarded; the iShares Barclay's 20+ Year Treasury Fund ETF (TLT) boasts a near 24% total return just this year. But, inevitably investors will return to real estate and stocks. This could trigger an exodus from now richly priced Treasuries, dealing you a significant loss.
3. Treasuries Provide You No Inflation Protection
Inflation has averaged about 3.1% annually over the last 100 years, and at times as been over 10%. In the last 12 months it's jumped to 3.6%. Unquestionably, a 2% yield on a 10 year treasury locks you into long term erosion of purchasing power, to say nothing of the 0.21% yield on the two year Treasury.
Those locked in losses still might prove small compared to the beating Treasuries could take should inflationary expectations really take hold and interest rates soar. Don't rule that out given that our Government is borrowing 42 cents for every dollar it spends.
4. Default Risk Has Risen, But Without Offsetting Compensation
A rating agency finally did it. Standard and Poor's downgraded US long term debt to AA+ from AAA on August 5. So far, investors seem to pay no attention, bidding up long dated Treasuries another 9% since then. Some take comfort that the other two major rating agencies, Fitch and Moody's, affirmed their triple AAA ratings.
Nevertheless, most agree that our finances face negative long term trends. However, Treasury investors are not being compensated for the additional risk they are taking. If five year AAA rated corporate debt yields 1.33%, why would you settle for the 0.97% being paid on similar maturity Treasuries? If you believe S&P, you're not getting paid enough to buy Treasuries.
5. Treasuries are Priced in Dollars, Another Risk
The Dollar's fallen about 10% over the last year versus a basket of currencies, including the Euro and the Yen. This erodes the purchasing power of your Dollar denominated debt, including Treasuries.
Because Treasuries, like most debt, provide fixed payments of principle and interest, they provide you no hedge against Dollar depreciation. Expect continued Dollar depreciation if our economy fails to recover. That's another reason you don't want to chase Treasuries now.
6. Treasuries Recent Outperformance Seems Poised to Weaken
Over the long haul, Treasuries have been poor performers relative to equities. Since 1926 Treasury bonds have returned 5.4% annually on average, equities 9.8%. However, since the early 1980s, Treasuries have been standout performers, particularly on a volatility adjusted basis.
This Treasury outperformance has been most pronounced in the last ten years; Vanguard's long dated bond fund (Vanguard Long-Term Bond Index (VBLTX)) has returned 7.47% annually over the last decade versus 2.6% for the S&P 500.
Given that yields on the ten year Treasury are down to 2% and that Treasuries have recently performed so well, it appears that some slowing and reversion to the mean is likely. That doesn't bode well.
7. Treasuries Offer No Protection Against Rising Interest Rates
Fixed rate paying Treasuries offer little protection against rising interest rates. Should rates rise, you'll be stuck with the old, lower payout, and your price to exit will be a function of the duration of the bond. The longer the duration (about equal to the maturity), the greater the cost.
How significant could the losses be? Expect a percentage loss equal to the duration for each one percent rise in rates.
The bottom line: Chasing long dated Treasuries via the TLT fund could throw you for more than a 15% loss should interest rates return to just those prevailing last New Year's Day.
Smart alternatives include floating rate debt, typically found in funds of bank loans. Treasury Inflation-Protected Securities (TIPs) might also be a good bet; while their payouts are fixed, the principal rises with inflation, and inflation often causes higher rates. Dividend paying stocks are also a possibility; historically dividend increases have outpaced inflation.
8. Treasuries Will Be Poor Performers in an Improving Economy
Following weak GDP growth in the first half and a plunge in several manufacturing indices the US may well be in recession now. This helps explain bonds' recent surge; a weak economy, keeping inflation at bay, is an ideal environment for Treasuries.
However, economies are cyclical. At some point our economy will strengthen, giving way to greater loan demand and higher prices for goods and services. As loan demand grows, interest rates will rise. As prices tick up, lenders will demand more interest to offset purchasing power erosion.
Treasuries, with their fixed interest payments and already high credit ratings, benefit little from better times. Preferable holdings might be high yield (a/k/a junk) bonds. Their higher rates reflect greater credit risk, but in an improving economy that risk may lessen, helping offset the adverse effect of rising interest rates.