Wednesday, December 7, 2011

Malkiel disses Treasuries, and he's right

Burton Malkiel, author of the classic (and frequently updated and highly recommended) A Random Walk Down Wall Street, and long-time proponent of portfolio diversification and the virtues of passive vs. active investing, has decided that enough is enough: government bonds stink. In his op-ed in today's WSJ, "The Bond Buyer's Dilemma," Malkiel takes the courageous step of urging investors to un-diversify their portfolios and actively eschew government bonds. And he is right.

I highly recommend his article, and I offer here some charts, thoughts, and additional recommendations to help flesh out his larger points. As the above chart shows, 10-yr Treasury yields today are as low as they have ever been. Malkiel argues that interest rates on government bonds are being artificially depressed by policymakers in an effort to "inflate away" the real and growing burden of debt. While that may be true at least in part, I prefer to think that yields are extremely low because investors are extremely fearful of the future and are willing to pay an exorbitant price for default-free, interest-bearing assets such as Treasuries, TIPS, German Bunds, and Japanese government bonds. Whatever the drivers of extremely low government bond yields, it is true, as he says, that:

Artificially low interest rates are a subtle form of debt restructuring and represent a kind of invisible taxation. Today, the 10-year U.S. Treasury bond yields 2%, which is below the current 3.5% headline (Consumer Price Index) rate of inflation. Even if inflation over the next decade averages 2%, which is the Federal Reserve's informal target, investors will find that they will have earned a zero real rate of return. If inflation accelerates, the rate of return will be negative.

Actually, the negative real rates of return are already with us. As the above shows, real interest rates on 10-yr Treasuries have been declining for the past 10 years and are now distinctly negative. If and when Treasury yields rise, real returns could not only be very low or negative, as they were in the rising inflation 1970s, but bondholders would also suffer from sharply declining bond prices as interest rates inevitably rise, thus suffering miserable total returns for years to come.

Malkiel recommends that investors who want a better alternative to the safety and income of government bonds should look to other bonds with "moderate credit risk where the spreads over U.S. Treasury yields are generous." He suggests municipal bonds, and I would add that lower-quality corporate bonds with generous yield spreads are also very attractive. As the chart above shows, the yield on high-yield (junk) bonds is almost 9%. That's a huge spread to Treasuries, and it signifies that investors perceive that many of these bonds are highly likely to suffer defaults in the years to come. But if you are even the slightest bit optimistic about the ability of the U.S. and most global economies to avoid a calamity, and if you are worried that super-accommodative monetary policies from most major central banks are going to push inflation higher in the years to come, then high-yield corporate bonds should do pretty well. Actual defaults are likely to be lower than expected if we avoid another economic calamity, and rising inflation will improve the cash flow of almost all corporate borrowers, which in turn would also work to reduce default risk. My chart compares the yield on high-yield bonds to 2-yr swap spreads, in order to show that the current level of systemic risk in the U.S. economy is relatively low, and that the yield on junk bonds is priced accordingly.

Malkiel likes the bonds of some countries, like Australia, where fiscal policy is a lot more conservative than ours (i.e., fiscal deficits are much lower) and interest rates are substantially higher. I would caution, however, that while his reasoning is sound, buying Australian government bonds is not a clear-cut, obvious strategy. As the chart above shows, the Aussie dollar is currently about as strong relative to the U.S. dollar as it has ever been (i.e., the gap between the current value of the currency and its purchasing power parity is huge, reflecting what might be called an "overvaluation" of the Aussie dollar). In other words, investors are well aware of Malkiel's arguments, and have already bid up the price of the Australian currency to reflect the much more optimistic outlook to be found there these days. If the outlook for the U.S. were to improve relative to the outlook for Australian, the Aussie dollar could suffer a significant decline in the years to come, thus wiping out most or all of the current interest rate advantage offered by Australian bonds. Hedging the currency risk is not a complete fix for this problem either, since current hedging costs run on the order of 4% per year.

Malkiel also likes "blue-chip stocks with generous dividends" as a better alternative, and I would agree. Not only are the dividend yields on many stocks competitive with government bond yields, but the earnings yield on the entire S&P 500 is much better than the yield on junk bonds, as my chart below illustrates.

This is a highly unusual state of affairs, since this chart shows that investors are willing to give up about one-third of the earnings yield on large-cap stocks (currently 7.5%), and forego any future price appreciation, in order to enjoy a privileged position in the capital structure and receive a yield of 5.3% or less on BBB corporate bonds. This only makes sense if investors are scared witless by the potential for a global economic and financial market meltdown.

What this all boils down to, of course, is that the major asset classes are priced to really awful expectations for the future. Government bonds with no default risk are priced at incredibly high levels, while just about everything else is priced to the expectation that the sky is going to be falling, and soon. If you agree with the doomsayers, then it makes sense to ignore Malkiel's advice. And who knows, perhaps the doomsayers will be right this time. But if you have even a shred of optimism; if you think that the U.S. economy is likely to continue to grow at least modestly while the Eurozone struggles and maybe suffers from PIIGS defaults; then the opportunities to be found outside of government bonds are fantastic. Faced with pricing that reflects the expectation of something like the-end-of-the-world-as-we-know-it, I'm an optimist. Even though I am fully aware of all the headwinds still confronting the U.S. economy.


vg said...

I think you are both right. I believe the Fed will do everything in its' power to keep rates this low, and fear will keep people compliant.

Benjamin Cole said...

Another tour-de-force by Scott Grannis, and I really enjoy reading Burton Malkiel--I think it was reading Malkiel's "Random Walk" many decades ago that in part resulted in my lifelong interest in investing and economies.

That said, we are in unusual times. We may be doing a Japan, in which case bonds are a good buy, as we may see even lower interest rates and deflation in the years ahead.

Japan bond buyers have "enjoyed" (if that is the right word) 15 percent deflation in the last 20 years, while Japanese stocks and bonds are down about 80 percent. The Japan GDP is lower now than 20 years ago, nominally speaking.

The Fed, meanwhile, is squeezing the life out of the economy, with an effectively very tight monetary policy.

I hope Malkiel is right, and some steady, moderate inflation is in the forecast. Real estate and equities could use a boost, and the economy is suffering from weak demand.

From 1982 to 2008, the USA economy prospered with mild and varying inflation from 1.8 percent o 5. 4 percent. Why now, with GDP 13 percent below trend and real estate in the dumps, we harp on 2 percent inflation? This is an unhealthy, peevish fixation on just one aspect of monetary policy, not a complete monetary policy.
The headline inflation is one thing, but core rates are near historical lows. And headline rates are up on 35 percent jump in globalized energy commodities. You won't get annual jumps like that for long--buyers won't be able to buy oil. Ergo, if energy prices stabilize or fall, we see deflation, or close to it.

McKibbinUSA said...

I did not find Malkiel's article in the WSJ to be completely coherent -- on the other hand, I agree that abandoning Treasuries makes sense -- I disagree that municipals are a suitable alterative -- rather, I advise going fully into dividend and rent-paying equities -- the coming bond market "blowup" is going to be unpredictable and certainly not safe -- good solid dividend and rent-paying equities are also risky, but less risky than sovereign bonds at this point -- preserving wealth is the goal, which is the same thing as asking where one will lose the least -- cash and bonds are in ugly territory and are being manipulated by central bankers -- as I have said before, everyone should be taking cover...

Benjamin Cole said...

The USA economy expanded mightily from 1982 to 2008. We had moderate and varying inflation, from just under 2 percent, to more than 5 percent, during that time. That is the historical record.
Why are we going into hysterics now at the thought of four to five percent inflation–especially when the GDP is 13 percent below trend and real estate is dead? said...

Saw this article this A.M.
Time to buy longer UST's is at the top (late in) of the business cycle like June, 2007 when the yields on long Treasuries approached 5.25-5.30%. About when the stock market is peaking. We are still about 180 degrees out of phase for such purchases.

Disclosure: fully invested in securities portfolio: equities, domestic and international; PCY, HYG, PFF, GSG.

McKibbinUSA said...

I just watched the ECB Pres Dr Mario Draghi's press conference, and I am now beginning to see that severe economic austerities are likely coming to Europe, and especially southern Europe -- the ECB is simply not going to monetize sovereign debt in Europe, regardless of the consequences for the Eurozone -- if the US Federal Reserve follows with a similar stance in the face of the impending California default, then the austerity hawks will have won the day -- said another way, Western civilization may be about to enter a new very dark time where capital is in very short supply, and where deficit spending cannot be funded by sovereign debt issues -- what will result are severe cuts in government spending accompanied much much higher taxes -- events in Europe may have decided our fate in the US -- prepare for monetary contraction, government spending cuts, and higher taxes -- depression is now falling upon the middleclass of Western civilization -- those holding high quality dividend and rent-paying equities will be the new lords of the world, at least in the West -- everyone else should be hoarding supplies and taking cover -- more at:

Donny Baseball said...

Remember the failed German bund auction of a few weeks ago that was deemed a "disaster" by market participants? If that can happen - out of the clear blue sky apparently - how close are we to a "bond market vigilante" type event here in the US? What could set it off? A bad inflation print, a less than robust auction, a fourth year of @$1.4 trillion Obama deficits (CBO said today we are on that pace with $240B deficit in first two months)???

Squire said...

Advocates of borrowing for government spending and for inflation are kicking the can down the road. It is a bet that increasing debt and money and will solve the current economic situation.
Remember those sayings from Benjamin Franklin? A penny saved is a penny earned. Neither borrower nor a lender be. (Shakespeare).
How quaint.