Saturday, June 14, 2008

On bond yields, treasuries and inflation

We’ve had Bill Gross coming out with a no holds barred scathing commentary on the US understating CPI. Other commentators have chimed in with a view that treasuries could be the most overvalued asset class in the world. (back in March)

I had an interesting email exchange which takes the opposite point of view(You should click the post link to view the emails). Here’s the email :

I have been a big proponent of the long-term US Treasury STRIPS. For the first ten years of their existence, 02/28/85-02/28/95, they were a far superior investment compared to S&P 500. Their total compounded annual return for the 10-year period was 15.3% compared to 14.14% for the S&P 500. Their beta was only 0.36 compared to the S&P 500.

1995 also happens to be the time when stock market investments were heavily pushed by 401-Ks based on their 3, 5, and 10-year returns. Were STRIPS, with superior returns and lower risk, offered as a choice in any 401-K programs?

The UST STRIPS have also been a far superior investment to the S&P 500 during the last ten years. The UST STRIP bought for $1,000 on 02/28/85, when first available, would be worth more than $9,000 today. We know that inflation has only been up by a factor of 2. Even for the conspiracy theorists it has not been more than a factor of 3.

Here was the reply:

Going long STRIPS in mid 80s, and staying long through the period of "the great moderation" was obviously a great strategy in hindsight. Gary Shilling was a famous advocate of the "Long Bond" through these 20 odd years.. (You can check his chapter from John Mauldin's "Just one Thing" for a quick review)

Going long bonds/STRIPS at the ridiculously low yields you have today is plan hara kiri. We might be in for a 10+ year bear market in STRIPS. If the US is understating true inflation, why would you be advocating a long STRIPS strategy now?

Buying treasuries at historic low levels is a crap shoot at best – sure rates might go lower, we might get a Japanese style deflation. But even in the unlikely case that happens, your upside is limited while the risk of being wrong is high, and the opportunity cost higher. CPI showed inflation at over 7% annualized! Kind of sucks to be losing money as treasury yields rise to a negative real returns.

Counter reply :
It was in February 28, 1985, when UST STRIPS began (the Treasury dept started to deal with them directly). The inflation had peaked five years ago and the headline inflation rate had come down to 3.52%! For the next ten years the long-term UST STRIPS out-performed the S&P 500 with a beta of only 0.36.

$1,000 invested in long USTs in Sep 1981 and then converted into STRIPS in Feb 1985 would be worth $20,000 TODAY and I expect that to be $25,000 by 2010. That is good enough for me. The Yield on the 10-Year will go below 2% and long-term UST STRIPS would out-perform. Inflation is in the process of peaking and will collapse 12-15 months into the recession.

Hmm. Certainly food for thought! I think there is a strong case to be made for a second half treasury rally.

I also highly recommend checking out John Mauldin’s Just One Thing for this and other similar interesting ideas.

On the back of this exchange, here’s an interview with Mr. Long Bond himself (Gary Shilling). He seems to agree with this point of view.

(Note: I haven’t checked the authenticity of the exact numbers, but the general trend is indeed right)

Disclosure: None