8 Reasons Why Treasuries Don’t Make Sense

The clock is ticking on the bull market in government bonds

   
8 Reasons Why Treasuries Don’t Make Sense

U.S. Treasuries have been the whipping boy of the investment world for months, yet — aside from a brief tumble last month — they continue to perform relatively well thanks to the continued demand for “safe” investments. Still, Treasuries might in fact be one of the most unsafe options that investors currently have.

The most frequently heard argument against Treasuries right now is “Yields have already fallen so far; how much lower can they go?” While this is a valid point, it overlooks eight other reasons that provide an even stronger case of why Treasuries are a poor investment:

1.) They Don’t Beat Inflation

The latest CPI data showed that inflation was up 2.7% over the 12 months ended in March (prior to seasonal adjustments). Even if you believe the official government data, every Treasury maturity with the exception of the 30-year (which is yielding 3.08%) will cause investors to lose money on an inflation-adjusted basis. As Warren Buffett pointed out in February, Treasury investors are steadily losing purchasing power even though the modest yield makes it seem as though they are making money. As a result, he noted, “Right now, bonds should come with a warning label.”

2.) Treasuries Are Overvalued Vs. Stocks

A classic method of measuring the valuation of government bonds is to compare the yield on the 10-year Treasury note to the earnings yield on stocks. (The earnings yield is earnings divided by stock prices, or the inverse of the P/E ratio). And right now, the 1.9% yield on the 10-year is far below the 6.92% earnings yield on the S&P 500 (as of May 11). This is the largest gap in 50 years, indicating that some mean reversion is in order. While this substantial gap has been in place for some time — meaning that it can’t be used as a short-term indicator — it is likely to be a factor in Treasuries’ relative performance in the years ahead.

3.) The Duration Math Doesn’t Add Up

The room for upside is extremely limited based on some simple math. Say the 10-year yield drops all the way to 1.4%. By multiplying the change in rates (0.5) by the 10-year note’s duration (9.1), the result is price appreciation of only 4.55% — even if yields move down another half-percent from here. The result: Treasuries are losing their ability to provide a hedge against a calamity in Europe or elsewhere.

4.) The Coupon Math Is Unfavorable

With yields so low, there is almost no leeway for investors to experience a price decline and still come out ahead. Consider the iShares Trust Barclays 20+ Year Treasury Bond Fund (NYSE:TLT), which at mid-day Thursday changed hands at a price of $117.81 and a yield of 2.89%. An investor who bought this ETF would see their annual income wiped out with a drop in its price to just $114.40 — a scary prospect considering that TLT fell as far as $110 during the bond wipeout in March.

5.) Treasuries Are a Bet on More of the Same

The rally in government bonds has been fueled by the three-pronged support from the flight to quality caused by the European debt crisis, the accommodative policies of the Federal Reserve, and the continued sluggish nature of domestic economic growth. If any of the legs of the stool are knocked out, the rally in Treasuries will come to an abrupt end. Of course, these conditions have been in place for several years now and there is no sign that they will abate in the immediate future. Still, investors need to be aware of what could happen if the status quo is disrupted.

6.) Most Other Asset Classes Meet or Beat Treasuries in Terms of Yield

Investors have a full range of income-oriented ETFs from which to choose, including equity products such as iShares Dow Jones Select Dividend Index Fund (NYSE:DVY), which has a yield of 3.62% — far in excess of TLT’s 2.89%. The competition from other income-producing equity asset classes such as utilities, REITs and MLPs hasn’t dented the performance of Treasuries yet, but this is likely to become an important consideration once one or more of the pillars mentioned previously begins to weaken.

7.) Uncertain Tax Policy

In his May 4 Wall Street Journal editorial “The 2013 Fiscal Cliff Could Crush Stocks,” Donald Luskin writes that if the current laws aren’t changed …

“… at year-end the top tax rate on interest income will rise to 43.4% from 35%. According to our simple arithmetic, if the yield on a 10-year Treasury is 2% today, it would rise to 2.3% with next year’s tax rates.”

Investors have been focused on the impact that tax policy will have on stocks, but government bonds also could take a hit if Washington fails to act.

8.) Weak Government Finances

No breaking news here, but the high and rising government debt makes U.S. government bonds a far more questionable credit than is implied in their current yields. The safest investment in the world? Perhaps. But safe on an absolute basis? According to TreasuryDirect, our debt stood at $15.685 trillion at the end of the day on Tuesday, up from $15.223 trillion at the start of the year. At some point, the government bond market will face a day of reckoning as the relationship between yield and risk becomes more realistic.

None of this should be taken as a prediction that Treasuries will collapse right away. The asset class has faced these and other headwinds for some time now, yet the 10-year note has traded comfortably in a range from 1.7% to 2.4% since last September. The result has been frustration for those who have tried to take advantage of this “easy” trade by buying inverse ETFs such as the ProShares UltraShort Lehman 20+ Year Treasury ETF (NYSE:TBT). Still, the clock is ticking on the Treasury bull market, and this is an important consideration for anyone who has exposure to any segment of the fixed-income universe.

What to Watch

Treasury 300x173 8 Reasons Why Treasuries Don’t Make Sense
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To determine the state of the market, keep an eye on the chart. The range on the 10-year is defined on the upper end by its 50- and 200-day moving averages (each about 2.09%) and on the lower end by its support line at 1.8%. The range is tightening, so we should see a resolution within the next two to three months. If this resolution occurs in the form of another break of the 200-day moving average, consider it the long-awaited buy signal on TBT.

In the meantime, watch for a move in the 50-day moving average above the 200 (the “golden cross”). This could be a potentially important sign that the technical outlook for Treasuries is finally starting to deteriorate.

As of this writing, Daniel Putnam did not hold a position in any of the aforementioned securities.


Article printed from InvestorPlace Media, http://investorplace.com/2012/05/8-reasons-why-treasuries-dont-make-sense/.

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