Treasury Bonds Are No Longer the Conservative Investor's Friend

For more than three decades, conservative investors have been able to count on Treasury bonds to deliver a consistent income stream, while providing a safe repository for principal. Further, Treasuries have anchored portfolios over their long bull run by limiting the damage when stocks declined.

However, with interest rates now at record lows, can investors reasonably expect Treasuries to perform any of these tasks well going forward? Intermediate Treasuries purchased today produce income below the rate of inflation. And while Treasuries are still considered safe, investors holding a 10-year bond with 2% coupon will suffer large opportunity costs if yields rise. Finally, given the huge interest rate risk inherent in longer maturity Treasuries today, even their ability to limit portfolio volatility must be questioned.

Negative Coupons

Let’s start with income - or the lack of it. Traditional savers have suffered the effects of low interest rates for a few years now. Let’s face it: the current 0.2% yield-to-maturity on the 2-year Treasury looks like a typo. Try writing “0.2%” on a sticky note, and under it, “Yield on 2-Year Treasury.” A zero before the decimal just doesn’t look right. Sure, the rule of the longer the maturity, the higher the yield still applies. But despite today’s fairly steep yield curve, even extending maturities out to 10 years results in a yield-to-maturity of just 1.7%. That’s lower than the 2.1% dividend yield on the S&P 500. In fact, 1.7% is not much higher than the 1.4% yield on the Russell 2000, an index of small cap stocks notoriously stingy with dividends.

The income generated by intermediate Treasuries looks especially meek compared to a dividend-focused basket of stocks. The popular Dow Jones Select Dividend Index, for example, currently yields 3.8%. The S&P 1500 High Yield Dividend Aristocrat Index yields 3.0%. The accompanying table compares the income generated by a hypothetical 10-year bond with a 1.7% coupon selling at par compared to a dividend-focused stock portfolio with a yield of 3.5% at purchase. We use a 1.7% coupon because 10-year Treasuries trade with a yield-to-maturity of around 1.7% currently, and assuming the bond is purchased at par simplifies the illustration. Meanwhile, we assume stock dividends grow at 6% each year. Interest payments come biannually, while dividends are paid quarterly. Income from both Treasuries and stocks is reinvested at 1.7% annually.

Income Comparison: Total income generated over 10 years: $100,000 investment
10-Year Treasury 1.7% Coupon	Stock with initial of 3.5% yield, 6% dividend growth
Income from coupons/dividends only	17,000	47,484
Total income including reinvestment at 1.7%	18,445	51,209

Not surprisingly, stocks deliver more income given their higher dividend yields. But what may surprise investors is the degree of the difference. The assumption that dividends grow by 6% annually is a key driver of income over the period. This seems a reasonable assumption as the dividend on the S&P 500 grew at a 6.9% rate over the 2002-2012 period, despite having heavy exposure to dividend-cutting banks during the financial crisis. So, thanks to 6% growth, annual dividends grow from $3,580 at the end of year one to $6,118 in year 10.

If income is the sole consideration, Treasuries can no longer compete with a portfolio of dividend stocks. This is a new development as Treasuries yielded more than stocks from the mid-1950s to the mid-2000s. In fact, if we assume a 5% coupon with the same 1.7% reinvestment rate, the Treasury portfolio generates more income ($54,251) than stocks in the above scenario. For the record, the 10-year Treasury had a yield of 5% as recently as July 2007. Of course, the Treasury bond will return in principal the full $100,000 in year 10 when it matures, no more and no less. If we assume the yield on the stock portfolio is 3.5% in year 10 (i.e. valuations don’t change), the market value would be more than $178,000 based on the final dividend.

Getting back to income, the meager Treasury bond coupons look even worse when inflation is taken into account. Inflation as measured by the CPI increased by 1.5% for the 12 months ended March. And that was the smallest 12-month increase since July 2012. In February, for example, the 12-month figure was 2.0%. Thus, it is not unreasonable to suggest that a 10-year bond purchased today could deliver negative inflation adjusted incomeeach and every year until maturity.

In contrast, a growing stream of dividends at least has a shot of outrunning inflation. In fact, dividends did just that over a period that included many of the most inflationary years in US history. From year-end 1970 through 1990, S&P 500 dividends outpaced the CPI, growing at a compound annual rate of 7.0% versus 6.2% for inflation. Now, the S&P 500 is hardly the benchmark index we’d use to generate a growing stream of dividend income. A professionally managed dividend-focused investment strategy can provide a higher yield and much better dividend growth prospects in our view. But we see no reason why even the low-yielding, modestly growing S&P 500 shouldn’t trounce a 10, 20 or even 30-year Treasury purchased today and held to maturity.

Safety of Principal

Most investors want to allocate a portion of their investments to “safe money.” Not only do they want these assets to retain their value, but they want them to be liquid and readily available. These are investments where the return of principal is more important than the return on principal. Treasuries – and bonds in general - are well suited for this task. For example, corporate bondholders are in line well ahead of stockholders in a corporate bankruptcy. And despite recent sovereign downgrades and threats of downgrades, Treasuries are generally considered among the safest credits on the planet. Finally, longer maturity bonds typically offer higher returns than guaranteed bank deposits. So what could go wrong?

Two things. First, investor plans sometimes go awry. Principal may be needed prior to maturity, forcing bond sales. In an environment of stable or declining interest rates, that is not a problem. In fact, with a positive yield curve, the closer a bond gets to maturity, the lower the yield - and according to bond math - the higher its price. But should the market push up bond yields after purchase, the bondholder could be forced to incur a loss. Whether a loss is realized depends on the coupon, the time left to maturity and the market yield.

The table below illustrates how a change in interest rates would affect the price of our same 1.7% coupon Treasury bond trading at par with 10 years to go until maturity. The table also shows the impact of rising rates on a 2.8% coupon bond with a 30-year maturity (the 30-year Treasury currently has a yield to maturity of about 2.8%):

Impact of Rising Rates on the Price of 10 & 30 Year Bonds
Yield to maturity change	1.7% 10-Year	2.8% 30-Year
+1%	-9%	-18%
+2%	-17%	-32%
+3%	-24%	-42%

A 24% loss on the “safe” portion of a 10-year Treasury portfolio could be devastating for a retiree who must sell down assets for living expenses. But even a 3% rise in rates would put our hypothetical 10-year Treasury at just a 4.7% yield. For perspective, the actual 10-year had a 4.7% yield as recently as August 2007. The chart below is a reminder that yields are the lowest in a generation. An investor doesn’t have to forecast interest rates to see yields this close to zero are the aberration rather than the norm over the last half-century:

Shrinking Principal

Rising yields will not affect a bond’s principal at maturity. However, if rates rise to 5% in five years, an investor who bought a 10-year Treasury at today’s interest rates is going to have a long wait before being reinvesting maturing principal at higher rates. This potential opportunity cost is a new risk for bond investors since rates have trended lower for more than 30 years. If rates reverse course and climb for 10, 20, or 30 years, Treasury purchasers will not incur losses at maturity, but the opportunity cost could be just as painful.

The other factor compromising safety of principal is inflation. Any inflation will result in the inflation-adjusted principal at maturity to be worth less, perhaps significantly less, than the original investment. This is always the case with bonds, but the likelihood of negative inflation-adjusted income throughout the life of a bond purchased today makes this attribute even more unattractive in our view.

Portfolio Volatility – Keep Both Hands on the Wheel

Treasury investors are often willing to accept the loss of purchasing power to maturity because of the certainty of principal at maturity and the bond’s stabilizing influence on the portfolio. Low portfolio volatility is particularly vital in the distribution phase in the event assets must be sold to cover living expenses. Selling assets at a loss shortens the life of the portfolio, perhaps to the degree that dramatic changes in a retiree’s lifestyle are necessary.

Bonds have long been considered the adults in the car, making sure the unpredictable teenagers (stocks) don’t drive the portfolio into the ditch. The problem with today’s bond yields is that such low coupons not only contribute little to total return, but they also make bonds more sensitive to changes in interest rates.

Let’s take a step back and consider why bonds have the reputation for acting as a counterweight to the equity allocation. In the last two stock market debacles, bonds turned in terrific performance:

Stocks vs. 10-Year Treasuries
S&P 500 Total Return	10-Year Treasury
Beg. Yield	End Yield	Beginning price	Ending price	Change in Price
3/24/00 – 10/09/02	-19.0%	6.2%	3.6%	100	117.0	17.0%
10/9/07 – 3/9/09	-42.9%	4.7%	2.9%	100	113.5	13.5%

While stocks took a 43% hit in the financial crisis, Treasuries stabilized the portfolio, and not just because more bonds meant fewer stocks. The positive return from Treasuries offset a good portion of stock market losses. For example, intermediate Treasuries gained more than 13% in the financial crisis, plus investors pocketed the coupon income. Because of bond math, longer maturities turned in even better performance as the change in rates had a larger impact on long-term bond prices.

Based on the figures above, a 60/40 stock/bond allocation would have resulted in less than a 20% loss over the Oct. 2007 through March 2009 period. Investors with a more conservative allocation towards Treasuries would have survived with even fewer bruises.

However, looking back at recent market declines, it is unusual to see Treasuries perform inversely with stocks. Typically, bond yields rise (prices fall) during an extended sell-off in equities. The table below presents periods of significant declines for the S&P 500. The yield-to-maturity on the generic 10-year Treasury is presented for the beginning and end of each period. We assume bonds are purchased at par and sold at the end of the period. We assume yield (and price) at sale corresponds to the 10-year Treasury even though the remaining time-to-maturity would be less than 10 years give the brief holding period. That is, the yield for bonds with the exact time remaining to maturity would differ slightly from the 10-year yields assumed.

Periods of stock market declines		S&P 500 Performance (ex- dividends)	Beginning Yield	Ending Yield	Beginning Price	Ending Price	Price Change
1/11/1973	10/3/1974	-21.50%	6.44	8.04	100	89.15	-10.9%
11/28/1980	8/12/1982	-19.0%	12.72	13.55	100	95.52	-4.5%
8/25/1987	12/4/1987	-33.5%	8.72	8.96	100	98.43	-1.6%
7/16/1990	10/11/1990	-19.9%	8.44	8.91	100	96.93	-3.1%
2/2/1994	4/4/1994	-8.90%	5.71	7.14	100	89.90	-10.1%

Note in the above table, even though yields rose in each period that stocks declined, 10-year bond prices never dropped more than 11%, and sometimes hardly at all. That’s because higher the coupon, the smaller the change in price for a given change in interest rates. In addition to dampening the effect of a higher yield on the bond price, income from those higher coupons offset capital losses. For example, the 12.72% coupon associated with a 10-year Treasury purchased in 1980 more than offset the 4.1% price decline from rising interest rates over the period.

It’s also important to realize that while bond yields rose (prices fell) during those periods stock market sell-offs, the overall trend of bond yields has been down since 1981. The strength and persistence of the bond bull market cannot be overstated. For example, an investor could have purchased a 10-year Treasury at the end of any one of 394 months since September 1981 and held it for five years. In only 22 of those 394 instances would the yield on the 10-year have been higher five years later. Investors have benefited from this bullish tailwind for a generation.

With bond yields so low, and coupons so small, bonds could have a very different effect on portfolios going forward.

Is There a Place for Treasuries Today?

Yes, but we would argue that Treasuries should not automatically represent a large percentage of assets. Financial advisors must adapt and realize that it may be prudent for some investors with long time horizons to avoid Treasuries altogether. Some may even want to include alternative asset classes to recreate the “balancing” role bonds have traditionally played. This may include a mix of high dividend paying stocks or utilizing market-neutral strategies. Simply holding more cash may be an option too.

In summary, conservative investors enjoyed a 30-year bull market in Treasuries. Those who bet heavily on Treasuries before the financial crisis scored large capital gains and continue to generate relatively high income from those big coupons. However, presented with today’s tiny yields and increased risk of principal loss, Treasuries need a hard second look before being fully embraced.

© Ranger International

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