US TREASURIES: Guaranteed to Disappoint, Part 2

Posted on Posted in Financial Blog

As we discussed in our newsletter, US Treasury securities are traditionally viewed as the safest investment you can make, but only because you will unquestionably receive your principal and interest on time. The problem is that your these payments will likely be worth less in real (spending power) terms by the time you receive them, potentially guaranteeing a loss. While we don’t see Treasuries performing well over the next decade, we do believe that there are a number of other, more promising investments you can buy without taking on excessive risk.

Professional investors measure return on a risk-adjusted basis, with the risk of an investment being determined primarily by its volatility, or uncertainty of future returns. If Investor A and Investor B both earned 15% per year over the last five years, but Investor A did it with municipal bonds (with low volatility) while Investor B did it with speculative Chinese company stocks (highly volatile), we can say that Investor A outperformed Investor B on a risk-adjusted basis. Because Chinese stocks are far more volatile than muni bonds, Investor B should demand a higher return than Investor A. The take-home message is that investors should be compensated for the level of risk they assume. Once investors start expecting interest rates to increase, volatility in the Treasury market will likely increase as well, and the potential return on Treasuries will no longer be sufficient to compensate investors for the risk they assume.

Where else can you invest safely?

There are three main categories of asset classes: Equities, Bonds and Hybrids. Equity represents (usually fractional) ownership in something—a company in the case of common stock, or real estate, or wine. A bond represents a debt owed to you by an issuer, paid back with interest. Hybrids are asset classes that are a combination of equities and bonds, or that don’t fit well into either of the first two categories (for example, commodities and hedge funds).

If you require safety of principal you should consider money market funds, short-term Treasury securities or short-term TIPS (inflation-protected Treasuries), as additional risk would be inappropriate. Absolute safety of principal is typically only required for portfolios with a short time horizon—less than 5 years or so—because the funds will be used within that period. For those of you with a longer time horizon (that’s most of us) who can sacrifice the perceived safety of stable principal and who need inflation protection,  here are several investment options that fit the bill:

High-yielding, stable equities

Thanks to massive cost-cutting and de-levering after 2008, the balance sheets of many companies are unusually strong—and strong balance sheets are good for income investors. When Wal-Mart (NYSE: WMT) brings in its revenue and pays out its expenses, it typically has a large chunk of change left over. It can either keep this money for future investments or return it to shareholders. Today’s investor sees the economy as unstable and would rather have that money paid out as a dividend than reinvested into the company, at least relative to years past. This is especially true in “boring” industries like consumer staples or utilities where revenues are stable and predictable from quarter to quarter, and growth tends to be slow and steady.

Today, Wal-Mart pays out $1.59 annually for each common share; at Friday’s close of $69.30 this represents a dividend yield of 2.3%. Not only is the dividend higher than the interest on a 10-year Treasury (currently 2.0%), but dividend income is also taxed at a lower rate, leaving you with more after taxes. Also consider that Wal-Mart (and other companies) offers appreciation potential—both in the stock price and the dividend payment—that Treasuries do not. Unless interest rates are going to drop to near zero, price appreciation in Treasuries is unlikely, and we know that Treasuries will suffer when interest rates start rising. Perhaps surprisingly, Wal-Mart stock has about the same volatility as a 10-year US Treasury note! And there are plenty of other stable companies offering attractive dividend yields along with potential price appreciation, whose volatility is not much greater than that of Treasuries.

Other fixed income

It may seem as if we are bearish on all bonds, and that is true to some degree; however, most portfolios should have at least a modest amount of fixed income. If you must buy bonds, consider (in order from least risky to riskiest): US municipal (tax-free) bonds, US investment-grade corporate bonds, sovereign debt of developed countries, investment-grade corporate bonds of developed countries, sovereign debt of emerging markets, corporate emerging market debt, high-yield bonds, and preferred stock. Municipal bonds are attractive to investors (especially high-earners) because you get to keep most or all of the interest. For other bonds you have to adjust for taxes using the following formula: %Yield*(1-t) where t is your marginal tax rate. Therefore, a Treasury yielding 2.0% (for investors in the federal 35% tax bracket) only pays you 1.3% on an after-tax basis. As you go further out on the risk spectrum you will find higher yielding bonds, but realize this is because you are being paid a premium for taking on additional risk associated with that government, firm or municipality.

Hybrids

Hybrids include commodities, convertible bonds and preferred stock, hedge funds, master limited partnerships (MLP) and private equity. If safety is the goal, hedge funds and private equity should not even be considered, as they are highly illiquid and often volatile investments. Commodities traditionally offer a hedge against inflation and may perform better in a declining economy (but pay no dividends). Convertible bonds and preferred stock can be converted into common equity, and usually combine the somewhat higher yields and greater safety associated with bonds along with some of the appreciation potential of equities. MLPs are tax-advantaged, publicly traded limited partnerships that typically derive their cash flows from real estate, commodities or natural resources. In order to keep their tax-advantaged status, MLPs have to pay out most of their cash flow to investors. Out of all the non-equity asset classes, we believe MLPs are one of the best options for the next decade, especially for individuals in the higher tax brackets.