YCG Investments
“If you buy above average businesses at below average prices, on average, we believe you should come out ahead.” — Brian Yacktman

Bond Bubble?

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Academia focuses much on modern portfolio theory. One of the major assumptions upon which this theory is built is comparing things to the so-called “risk-free rate,” which in practice Treasuries are used as proxy. But are Treasuries really risk-free? We want to dispel the thought that just because something is labeled as a “bond”, it is somehow less risky than an equity. Labels aside, whether it be called a bond, equity, or real estate, when discussing expected returns and risk levels of any asset, all that matters is how much cash you are receiving, what is the predictability of that cash flow, and how much you are paying for it. In modern portfolio theory, risk is measured by volatility. We, however, view risk as a permanent loss of capital, and even better said, as a loss of purchasing power. Without even delving into the debt loads this country is facing, let’s just go on the assumption that Treasuries will not default. True, you will receive your principal back plus some interest along the way. However, if there was inflation far greater than interest received over that time frame, you have experienced a loss of purchasing power, and thereby a permanent loss of capital. More importantly, what if you decide you want to sell this so called “risk-free” asset rather than hold it to maturity?

For instance, today, the 10 yr. Treasury is yielding approximately 2.5%. Let’s suppose interest rates increase by only 1% over the course of the next year (which is certainly not out of the realm of possibility – just as recently as this last April, the 10 yr. Treasury was yielding 4%). If in one year you wanted to sell your bond, it would now be selling 7.7% below par. Thus, when you add back in the 2.5% coupon you received, you would have experienced a 5.2% loss in a “risk-free” asset. As the duration of a bond increases, so does the sensitivity, making this scenario look even worse for a 30 year Treasury. Over the past year, they have ranged from 3.5% to 4.85%, and are currently at 3.7%. Again, suppose interest rates increase by a mere 1% over the course of the year. One year later the principal will now be worth 15.7% less, so when you add back in the coupon payment, you would have experienced a 12% loss!

Let’s go beyond the hypothetical and look at some real history. Here is a selection taken from a May 22, 2010 Barron’s Editorial Commentary written by Thomas G. Donlan, “In that hypertensive time at the end of the Carter administration, bond investors were skeptical of everything, because they had been burned so much, so often. It took a coupon yield of 10% to make the market open its eyes. At first glance in the spring of 1980, the 10% Treasuries looked attractive…Even the risk imposed by the high inflation of the time seemed worth taking in return for a seductive 10% yield. The “perfect 10” issue marked only the third time that the U.S. had paid a coupon yield in double digits. Wall Street quickly took a cold shower. In the first day of trading, the 10% bonds fell 3½ points, earning them a new nickname that reinforced bond traders’ reputation for mordant humor. “Buyer enthusiasm for the 10% Treasury issue had been so poor that dealers had labeled the issue the DC-10s, because they crashed on takeoff,” said the Wall Street Journal’s bond column on May 12, 1980. (An American Airlines DC-10 had crashed in Chicago the year before.) That was only the beginning. A year later the price of DC-10 bonds was down 40%. The Treasury was selling new 30-year bonds paying 15% interest…”

There has been lots of talk lately about a “bond bubble.” In 2009, Warren Buffet wrote in his annual letter to shareholders, “When the financial history of this decade is written, it will surely speak of the Internet bubble of the late 1990s and the housing bubble of the early 2000s. But the U.S. Treasury bond bubble of late 2008 may be regarded as almost equally extraordinary.” On the other hand, others argue this is no bubble caused by irrational exuberance, but rather our own government and foreign investors buying up Treasury debt. Some say it’s simply rational investors moving money out of lousy yielding money market funds and into Treasuries for higher yields.

Whether or not you want to call it a bubble, what does seem clear to us is it is not an attractively priced asset, and certainly not risk-free. In our minds, Treasuries are actually riskier than some equities. We have a hard time understanding why someone would prefer a Treasury yielding 2.5% over a wide selection of recession-resistant, high quality, multi-national corporations that are trading at low valuations from historical standards. They are a growing asset that has the ability to adapt to changes in prices (almost like a built-in TIPS). Not only are their free cash flow yields significantly higher than Treasury yields, but even their dividend yields are currently higher…and again, I note, are growing. Looking in the rear view mirror, for decades Treasuries have performed well because we have been in a declining interest rate environment, whereas equities have suffered because they were grossly overvalued. Looking forward, we feel bad for the lay investor who sees this comparison of past performance, and is now taking comfort because some financial advisor has neatly allocated a portion of their assets towards this so called “risk-free” asset…if only they knew.

Disclaimer: The specific securities identified and discussed should not be considered a recommendation to purchase or sell any particular security. Rather, this commentary is presented solely for the purpose of illustrating YCG’s investment approach. These commentaries contain our views and opinions at the time such commentaries were written and are subject to change thereafter. The securities discussed do not represent an account’s entire portfolio and in the aggregate may represent only a small percentage of an account’s portfolio holdings. These commentaries may include “forward looking statements” which may or may not be accurate in the long-term. It should not be assumed that any of the securities transactions or holdings discussed were or will prove to be profitable. Past performance is no guarantee of future results.

Posted by: Brian Yacktman | September 30, 2010 | Permalink

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