If you’ve read our newsletters and/or blogs, you know that we avoid making investment guarantees, as the future is inherently unknowable. However, one thing we can say with much confidence is that there is virtually no chance that US Treasury securities will perform as well over the coming decade as they have over the past 10 years. In fact, we think Treasuries will be big losers over the next several years.
How well have they done recently? For the 10 years ended January 31, 2013, the iShares 7-10 Year Treasury ETF, which invests in intermediate-term US Treasury notes, had a total return of +79.2%, or +6.0% per year. After inflation that equals +3.5% per year, considerably higher than the historical average of +1.8% per year. Over the same period, the S&P 500 returned +112.0%, or +5.3% per year after inflation; this was well below its long-term average of +6.8% per year. Will the next 10 years be similar, with Treasuries outperforming and equities underperforming? We think not.
Run for “safety”
US Treasuries are the “safest” investment in the world in just one way—you will unquestionably receive your interest payments on time and your principal will be returned at maturity. This is why investors flocked to Treasuries in 2008 following the global economic downturn, and why Treasuries still yield so little today. People who had been burned by the stock market and other “risky” investments decided to opt for safety over opportunity, perhaps a logical decision at the time but one that has made it increasingly difficult to generate good returns from fixed income investments.
Today, a 10-year Treasury note yields just 2.0%. You lend the government $1,000 today in exchange for $20.00 annually in interest, and on January 31, 2022 you receive your $1,000 back. If the choice is between 10 years under your mattress or the Treasury, go with the latter because at least you will be $182 richer. However, the same bond market that’s pricing 10-year Treasuries at 2.0% is pricing inflation over the same period at 2.6% per year. Thus, your after-inflation return would be -0.6% per year, or -5.5% over 10 years. But don’t forget taxes: at a marginal rate of 28%, Treasuries today are only yielding 1.4%, so your annual loss is actually -1.1% after inflation, or -10.6% over the next decade. Are you really so eager to lock in a loss of spending power over the next 10 years? Invest $1,000 now; walk away in 2013 with $894 after inflation and taxes. What price “safety?”
If the expected return for Treasuries is so crappy, why are investors still buying them?
The majority of Treasuries are owned by large financial institutions, non-financial corporations, and government (our Fed and foreign governments like China)—sophisticated investors for the most part. Governments and financial institutions hold Treasuries mainly because they have so few other options, given regulatory and other restrictions. Investors who have choices, whether individuals or institutions, hold Treasuries in part to guard against another financial meltdown, with memories of 2008 still fresh. While we are certain that another financial crisis will occur, perhaps on a similar scale to the last one, we doubt it will occur within the next decade, or even the next 30 years. Crises of such magnitude typically happen only a couple of times in a century. But investors, even “sophisticated” ones, typically fight the last war for far too long.
The bond game is simple—if interest rates go up you lose because bond prices fall; if interest rates go down you win as bond prices increase. [Read that last sentence two or three times to be sure you understand it.] As you can see below, bondholders have been big winners over the past two decades as they watched the prices of their bonds appreciate as interest rates fell to historic lows. In order for the bond bull market to persist, one or more of the following needs to occur:
(1) Deflation – The average prices of goods and services in the US would have to persistently decrease over several years, such as they did here in the 1930s and Japan over the past 2 decades. This is unlikely because the Fed has been so aggressive at increasing the money supply. And remember, over the past 100 years, inflation has averaged +3.2% per year. Even since the financial crisis (2008-2012) it has averaged +1.7%.
(2) Historically low interest rates persist – Interest rates would have to stay at these unprecedented levels over several years, which would require (as the Federal Reserve recently made clear) both persistent unemployment (above 6.5%) and low inflation forecasts (less than 2.5%) for some time to come.
But let’s give today’s bondholders the benefit of the doubt. Assume we purchase a 10-year Treasury today for $1,000 at a 2.0% yield. How do we do if two years from now, 10-year rates drop back to their all-time low of 1.5%? Our $1,000 bond will be worth $1,037 in 2015: including interest, we’ve made $77 or +7.7% over 2 years before taxes and inflation (roughly +6.0% after). Now let’s go crazy and assume 10-year Treasury rates plummet to 1.0% in 2015. Your $1,000 Treasury would be worth $1,077 in this scenario, for a total return of 11.7% (+9.4% after taxes and inflation) in this extremely unlikely, best case scenario.
If you think the best-case scenario isn’t so great, get ready for the worst-case scenario. All it will take for Treasuries to get mauled over the next few years is a very modest uptick in interest rates.
If the 10-year rate increases to 3% by 2015, which isn’t unlikely, the price of a 10-year, 2.0% Treasury issued in 2013 falls to $930 (-3.0% loss before taxes and inflation, roughly -8.3% after). If rates were to climb to 4% by 2015, another likely scenario considering we saw 4% as recently as 2010, your 10-year Treasury falls to $865 (-9.5% before taxes and inflation, roughly -13.8% after). And if rates go up to 5.8%, their average since WWII? Forgedaboudit!
But this isn’t the worst of it. While you might be able to live with a -13.8% loss on your Treasury investment over the short term, knowing that you’ll still get your $1,000 back if you’re willing to wait another 8 years, the longer-term effects of gradually rising interest rates and inflation are devastating, but barely noticeable in the short term. Similar to the erosion of rock by water, you don’t see what’s been happening until many years have gone by.
As an historical example, let’s look at what happened to Treasury bond investors from 1963 to 1973, before inflation really started to kick in. At the start of 1963, 10-year Treasuries yielded 3.8% and ended the decade at a 6.4% yield. Inflation during this period averaged 3.4%. Tax rates were much higher, but we’ll impute a 28% AMT rate to be generous. So what was the after-tax, after-inflation return to 10-year Treasuries during that rather prosperous decade? Exactly -0.635% per year, or -6.2% for the decade. At least inflation was lower than Treasury yields at the time, unlike today.
Amazingly, after that experience, many people bought Treasuries in 1973, perhaps assuming the worst was over. During this next decade, rates went from 6.4% to 10.4%. Inflation averaged a whopping 8.7%. How did the Treasury investor do, after taxes and inflation? He “earned” -3.7% per year, or -31.5% for the decade. Terrific: invest $1,000 in the “safest” investment in the world; get $685 back in 10 years.
In sum, we believe that, over the next decade, the Treasury market offers more downside than upside, and there are much better places to invest. In Part 2 we will discuss other asset classes (not just equities) that we believe offer better opportunities for return than Treasuries with little additional risk.