09 Jul 2013 Why Do We Own US Treasurys and Why Do Ships Sink?
Why do we insist on owning Treasurys when ‘everyone’ knows they are going to go down in value? Please allow me to answer this question metaphorically, beginning with another question:
Why Do Ships Sink?
Consider the tall ships of yesteryear. From a distance, they were beautiful silhouettes on a blue horizon with their tall masts, rigging, and brilliant sails reaching far into the sky. But closer up one would be awestruck by the immense power of the wind-grabbing rigs that drove these long, heavy hulls through deep waters over great distances.
Now if a person had no more knowledge of a tall ship than that just described, he might understandably be prone to some serious miscalculations, even disastrous mistakes. For instance, on a beautiful day he might be tempted to add sail to increase his speed. With limited knowledge or respect for the magnitude of the forces already at work on his vessel, he might not realize the potential for great harm. Squalls can come up very quickly at sea, and often precisely at the wrong time. Stiffening winds can easily overwhelm a heavily-canvassed rig to bring down her mast or capsize her altogether.
Tall ships are carefully and efficiently designed for long ocean voyages, built to perform well in all kinds of weather and seas. Up to this point we have touched only on the beautiful and the powerful components of our tall ship. The most important elements of any efficient sailing ship are hidden below her waterline. These vitals are of course her keel and ballast.
The keel enables a sailing (or any) vessel to move forward through the water even as the wind buffets from her side. Keel and ballast work together to hold the vessel and her tall mast and sails upright against the powerful forces of pounding wind and waves.
Our tall ship is a metaphor for an efficient investment portfolio which is designed for long periods and enduring the worst of stormy markets. In our tall ship metaphor, the mast, rigging and sails represent the stocks, the equity, or risk investments – the driving force that propels it along its journey, outpacing the currents of inflation.
Unfortunately, most people spend all of their time above the waterline giving little or no credence to the health of the keel and amount of ballast required for stability. Their only concern is speed, and during fair winds and weather their way seems right to them. But stormy seas will certainly come one day.
Below the waterline lies the foundation of a sailing ship. There’s nothing sexy or beautiful about it – UNTIL YOU NEED IT. If you’ve ever been at sea during a life-threatening storm you understand the unquestionable bond that forms between you and the deck, hull, and keel beneath your feet. Despite the immense buffeting of the wind and pounding of the waves, amidst all of the chaos, you feel a confidence deep inside yourself and your vessel as she powers indefatigably ahead.
US Treasurys are the foundation, the not-so-sexy keel and ballast of the best designed portfolios built for long-term voyages. They provide stability and positive persistence during the roughest of market conditions. Remove them and risk significant damage or capsize as financial storms just like natural ones will indeed blow up, seemingly right out of the blue, bringing potential disaster to the ill-prepared.
Our portfolios are designed for the long-term and for the storms that lie ahead. They cannot nor should they be steered clear of short-term squalls. No one knows when or from where they will come . . . or end. A captain sending his crew up and down the rigging to change sails for every weather change would surely exhaust them and increase his odds of being wrong with each sail change or tack. The result would be far slower progress than simply staying the course.
Sail on me’ hearties . . .
Treasurys on a more technical note.
Treasurys have been unusually burdened in the past couple of years with a premium added by Federal Reserve buying programs known as QE1, 2, and 3 which put a floor under their already steep values. Everyone knew the program would eventually come to an end and that they would loose that premium most recently associated with QE3.
On June 19th Ben Bernanke ended speculation by framing a clear end to his buying program. In the two weeks that have followed his announcement the IEF 7-10 year US Treasury Index fell as far as 4.5%. It has regained a full percentage point of that now, down 3.55%. In light of these movements, it can be argued that the largest, most heavily traded and most liquid market on the planet has already fully digested the news and eliminated any residual premium that existed from QE3. In fact some bond experts say the Treasury has been oversold at this point which is reinforced by their strong rebound of the last couple of days.
There is an additional challenge faced by Treasurys in particular and bonds in general, that they trade at all-time highs and have nowhere to go but down. Treasurys have appreciated rather steadily for the past 30 years and people wonder how much longer they can go on.
We do not know, but remember, we do not own them for their appreciation potential, nor do we greatly fear their downside potential. We look at them as the cheapest insurance available to offset the volatility risks of stocks. The 7-10 year Treasury index has never lost more than 9.5% in a 12-month period and never experienced two 12-month declines. This is reasonably priced insurance.
