01 Feb 2013 It’s OK for Treasuries to Decline
Last weekend I received an email from a client expressing concern about the US Treasuries we hold in her account. She had seen some dire warnings about bonds and particularly Treasuries in the recent media. Given the importance of Treasuries to our portfolio strategy and the rising concerns being stirred by investment gurus and financial media, it seemed appropriate to address Treasuries’ unique qualities that are largely ignored by today’s financial services industry.
Her email referred to following remarks made by Blackrock CEO Larry Fink (providers of iShares ETFs):
“We are seeing a broad-based movement into equities worldwide.” “No question, the move back into equities is one of the mega trends we witnessed in the fourth quarter, and that has continued into the first 15, 16 days of the year”. “Clients are analyzing the risks in longer term bonds and saying ‘I could do better in equities’. It’s a relative value trade, not a re-risking”, he said.
The note continued with a warning from a friend saying, “don’t let your advisor keep you in bonds too long. I am not saying to chase the equity market here, in front of Q4 earnings, but a lot of very smart people think the ride in bonds is coming to an end.”
Comments like these are typical of the marketplace. But we should remember, that for every seller of a bond or stock there is a buyer with a different opinion or purpose for doing the transaction. When we hear words like ‘trend’ we pay special attention because no one wants to be left behind. Mr. Finks’ use of the term ‘mega trend’ further peaks our interest; in this case to a major shift by investors out of bonds and into stocks. Our client’s friend endorses the strategy saying the smart play would be to get out of bonds altogether.
The problem with this reasoning is that it ignores the integral relationship between stocks and bonds that is indispensable in creating an efficient portfolio. When stocks decline in value, bonds usually increase in value and vice versa. Another problem rests in the idea that trends can be trusted as accurate indicators of future market movements. The practice dangerously ignores the consequences of being too concentrated on one side or the other when the trend reverses and moves violently against the strategy. In my experience, it is much easier to spot a trend and to become enamored with it than it is to know how and when it will play out.
Because we invest to accomplish important life goals, we do not construct our portfolios on future bets. Instead we build them to efficiently harness the immense financial power of the capital markets with as little loss as possible going to expenses and taxes, and mitigating, to the extent possible, the inherent risk in stocks. We accomplish this objective by employing Treasuries.
US Treasuries are peerless among bonds for several notable reasons. Guaranteed by the full faith and credit of the US government they are the strongest, safest bonds on the planet. No one has ever lost a penny holding a US Treasury to maturity. They trade in the most liquid market in the world. Foreign governments hold their foreign exchange (dollars used for trade) and their surpluses in them. The Social Security Trust Fund invests solely in Treasuries. And finally, the Federal Reserve uses them to execute its monetary policies in ways that more often stabilize their value.
Treasuries serve a vital role in portfolios as they behave like the shock absorbers on your car to smooth the bumps and potholes. When portfolios become over-weighted in stocks or when lesser shock absorbers aren’t up to the task, clients can be jarred off the stock market road, sometimes for good. Take a look below to see how shock-absorbing Treasuries increasingly ‘smooth the road’ as their allocation is increased relative to stocks.
These graphs represent six of our model portfolios over identical periods of time, from the market peak on 10/07 to present, which includes the ‘mega-pothole’ of the 2008 crash.
As Treasuries increase in their allocation relative to stocks, the impact of shocks diminishes. The deep ‘V’ seen in the 100% Stock Portfolio graph represents the 36.5% drop our all-stock model experienced while the light green line represents the 37% drop in the S&P 500. In the next row observe that the 37% Treasury portfolio declined only 10% while our most conservative portfolio of 60% Treasuries (on right) declined by less than 2% in 2008. Our clients remained as comfortable as possible during a very unpleasant and bumpy time for our country.
More compelling still is a comparison of how well Treasuries did relative to other shock-absorbing strategies used in the financial services industry (as represented by hundreds of mutual funds) including gold, real estate and commodities. In 2008 our 60% stock and 37% Treasury model declined by 10%. But an average of 760 mutual funds, that according to Morningstar most closely fit our model, fell by 22%.
The difference in large part can be explained by the preference of most fund managers to use corporate bonds and alternative investments like real estate, precious metals etc. instead of Treasuries to fill their fixed income allocations. They and their clients prefer higher yields and more pizazz in the defensive part of their portfolios, but the 2008 experience clearly shows that alternative strategies to mitigate stock market risk failed when it was needed most.
During the 2008 crash the 7-10 year Treasury index (the maturity range we use) was up 16%. Corporate bonds rose only 0.11% and international bonds were largely flat to down. Gold was up 5%, real estate collapsed between 40% and 52% depending on the index, and commodities dropped 46%. See these and other index returns in a white paper on our website written by Dave Loeper entitled Fake Diversification.
It’s OK for Treasuries to Fall
Most individuals buy bonds for their income, not for their defensive purposes. Declines in value can indeed be a warning when bond quality declines. But market losses in Treasuries do not mean that holders may be harmed, holders can be assured of getting back every penny of interest and principal if held to maturity.
But if one holds Treasuries for defensive purposes, he or she learns to accept cyclical price swings as normal ebbs and flows of the economic cycle. They rise in value when the economy is doing poorly (people want security) and they fall when the economy improves (people want the gains of stocks). But because of their persistent interest payments and guaranteed return of principal, declines are surprisingly limited.
Even during the worst of times, the 7-10 year US Treasury index has never fallen more than 10% on a total return basis in any given 12-month period for the past 87 years. Treasuries have held up remarkably well during extended inflationary periods as well. See Dave Loeper’s white paper entitled Gold’s Twelve Month March to $3,800 an Ounce. In his paper, Loeper demonstrates three periods of significant US inflation. During the early 70’s when inflation reached a 12-month high of 12.3% Treasuries ironically gained a compound return of 5.4%. Their worst 12-month loss was 1.8%.
During the 4-year inflation spike between March of 1978 and February of 1982 inflation averaged 10.7% and peaked at 14.8%. Over that nearly four-year cycle Treasuries’ compound return was 2.7% which included a 12-month loss of 9.5%.
While we may experience worse inflationary periods in the years ahead, there is no reason to expect that Treasuries will behave significantly differently than they have so far. Given their limited downside, low fund expense, and unparalleled defensive characteristics the 7-10year US Treasury index is the very best hedge available today. If or when that changes, rest assured, we will adjust accordingly.
The Best Way to Generate Investment Income
Finally, if bonds alone are not the best way to generate income, what is? As you likely guessed; its the combination of stocks, bonds, and cash together, monitored for the most appropriate allocation required to confidently meet the specific cash flow requirements for every unique client situation.
As demonstrated, stocks can be made safer for conservative clients by using Treasuries to offset market shocks. But stocks are also made safer by holding large numbers of them, being massively diversified. The equity or stock component of our portfolios is comprised of more than 5,500 corporations. The average mutual fund holds only hundreds of stocks. You would be surprised to find that adding multiple mutual funds to your portfolio does not significantly improve your diversification because of substantial overlap of leading companies. But a broadly diversified stock portfolio effectively captures the growth and income potential of the global marketplace.
On balance, corporations are very good at improving their sales and their profitability. Holders of their shares benefit as their dividends and share prices rise. Both are treated much better by the tax code than the interest from bonds. Inflation is less a threat than it is to bonds because dividends and prices generally rise considerably faster than inflation does. Companies can generally raise the prices of their goods and services to compensate for inflation.
A Deliverable Value Proposition
The industry practice of chasing trends in the name of providing better returns is not a deliverable value proposition. The numbers, and perhaps your own experience prove the point. A focus on returns does not confidently provide you the wealth required to meet every goal you value. In fact, every time you or your managers bet on a trend that doesn’t work out or you fail to vacate one before it collapses, your chances of meeting your lifestyle goals becomes a little farther from your reach. Every penny of taxes and expenses you pay to chase an unknowable future drains that much more compounding potential from your portfolios. And every market pounding you take makes you all the more weary of the game.
There is a better way to invest for today’s or tomorrow’s spending needs. By efficiently controlling expenses, taxes and under-performance, and planning for the uncertainty of the capital markets you can confidently meet or exceed every goal you value.
Accept the rise and fall of Treasuries just as you accept the cycles of stocks. They are normal. Worrying over market trends distracts the better of your attention away from your plan, the goals you value. We will call you when your plan, because of market trends, has become over- or under-funded. In other words, the confidence of reaching your goals has become uncertain and just as important, when opportunities exist to improve or add to your goals. In such cases, we will recommend actionable remedies that will get you back on track. Because we paid attention during our planning sessions, you will find our advice to be comfortably aligned with your priorities. That is a value proposition we can deliver.