Wednesday, June 17, 2009
This chart is set up so that when the two lines overlap, a 30-year T-bond will pay you 2 percentage points more than core inflation, as measured by the CPI. Many would consider that to be "fair value," since over long periods that is about what the real return on long-term Treasury bonds has been. As you can easily see, however, for most of the past 20 years T-bonds have yielded much more than their fair value yield, until recently. Right now you could say that T-bonds are trading at fair value, if you believe that core inflation is going to remain around 2% forever.
If inflation rises, however, T-bonds are going to deliver miserable returns. Either their yield will remain low, lagging the rise in inflation (in which case their real yields will be less than 2% per year or even negative), or yields will rise as inflation rises and the price of the bonds will fall. In the case of the current 30-year T-bond, its price will fall about 17% for every 1 percentage point rise in yields. Just a modest rise in inflation and yields could wipe out several years of coupon payments.
Since early 1980 and up to the end of last year, T-bonds delivered excellent returns, but that was mainly because their yields were much higher that inflation, and declining. Returns were excellent because the bond market was chronically over-estimating the rate of inflation. Now the bond market is betting that inflation will remain around 2% forever. Importantly, the fears of deflation which pulled bond yields down at the end of last year have all but vanished. But the bond market is not at all prepared for an eventual rise in inflation.
Full disclosure: I am long TBT at the time of this writing.
Posted by Scott Grannis at 11:05 AM