Is your financial advisor still robotically-allocating to this and similar securities? If so, keep reading.
In this article, for an individual’s long-term investment portfolio, I compare the environment today for 10-yr U.S. Treasury Notes (“Treasuries”) against historical or textbook observations.
10-year Treasuries are a bad investment right now:
- You can expect to lose value over time, after taxes and inflation. This is not market-timing. It’s basic math: taking the current environment as is, adding only the passage of time.
Taxes matter; Inflation matters:
- Inflation is anyone’s guess. Approx. 2% might not be a bad guess. The Federal Reserve oversees monetary policy and they have an explicit target of 2%. Market prices currently imply 1.75%. Considering the Fed’s other function of promoting maximum employment, if anything, gives them an incentive to overshoot vs. undershoot.
- Taxes are as unavoidable as brokerage costs. Uncle Sam’s share, or the federal tax rate on U.S. Treasury income, is 25%-43% (starting at $50K of income).
- Thus, a 2.1% pre-tax yield on the 10-yr leaves you with a mere 1.2–1.6% after-tax.
- Taxes also matter in your IRA or 401(k) account since, before you can spend the money, you owe federal and state ordinary income taxes on those gains. For example, in California, the net federal + state tax rate is 33–49% (starting at $50K of income) — yes, even higher, in this case.
Diversification benefits are limited; expensive at best.
- We’ve had three rate-hikes since December, increasing the Fed’s overnight rate by 0.75%. Parking money in safe short term securities is more profitable today, yielding 1.2% vs. 0.6% a year ago.
- Regarding Treasuries’ negative correlation with equities, which is to say in those situations where “stocks go down, bonds go up”, now that short term alternatives offer significantly more yield, in those times of a flight to safety, the “upside” appears more limited for the 10-year at 2.1% current yield.
- Downside risk: if interest rates go up, you will lose even more value: such as if you sell before maturity, for a capital loss, or if we experience higher inflation.
Among other things, a well-constructed investment portfolio needs consider current expected real returns and not robotically follow outdated portfolio allocation assumptions from a different era.
Diversifying alternatives are out there — without adding negative real returns — you just have to look harder than usual today.
U.S. Treasury Bonds have four key features:
- Profit: Rate of return, vs. inflation & taxes
- Diversification benefits in a broader portfolio: “stocks go down, bonds go up”. Specifically, to smooth out investment returns and reduce downside exposure to the timing of one’s investment, relative to market cycles.
- Liquidity: you can instantly and at negligible cost get in and out: exchange for cash.
- Safety or Insurance-value: U.S. Treasuries are the safest bet that you will get back what you expect because they are backed by U.S. taxpayers.
Let’s compare those features, in today’s environment, in the context of an individual’s long-term investment portfolio.
real return = pre-tax return, less taxes, adjusted for inflation.
Starting with a current pre-tax yield of 2.1%, the after-tax return will be 1.19% to 1.58% vs. 10-year inflation rate of 1.8% — 2.0%
The federal tax rate on U.S. Treasuries is 25% — 43.4% (starting at $50K of income).
In a 401(k) or an IRA, you must still pay state + federal ordinary income taxes on the gain before it can be spent. If you retire in California, the combined income tax rate on retirement distributions is 33% — 49% (starting at $50K of income).
NOTE: the fastest marginal tax calculator on the Internet can be found here: http://MarginalTaxes.com
Some 10-year inflation options:
(a) The Fed’s explicit target of 2%
The Federal Reserve has an explicit inflation target of 2%. It is their function to conduct monetary policy to achieve this target. Their additional function of promoting maximum employment, if anything, provides an incentive to overshoot that target.
(b) The Cleveland Fed’s estimate is 1.8%
The Federal Reserve Bank of Cleveland maintains a robust inflation expectations model. Their current 10-year estimate for the Consumer Price Index (CPI) is 1.8%. This is also the average for that measure for any time period looking back the past several years of monthly estimates.
There are a lot of outdated asset allocation assumptions in use today. Much of the academic research to date has been based on a unique time in history, as shown above, with an unprecedented bull market in bonds since 1981. That chart is a perfect example of “past performance is no guarantee…”
After-tax profit from Treasuries of 1.2–1.6% in today’s environment is unlikely to beat inflation.
“Stocks go down, bonds go up” or the negative correlation between the S&P 500 and 10-year Treasuries
Treasuries historically provided a positive real return and diversification benefits with equities. Finance professors for decades have called that combination the best “free lunch” in town.
No question, adding fixed income (bonds/interest rate risk) to a equities portfolio is generally diversifying. Bonds and equities are driven by various environmental forces. Some of these relationships are the same (i.e., will not diversify) and some are different (i.e., will diversify).
How diversifying is it, today, to add Treasuries and is it worth the cost, considering the negative real return, after-tax?
The all time low yield for Treasuries was 1.37% on July 5th, 2016. Even if the 10-year yield returned to that level, you would gain less than 7%.
This begs the question of what it would take for yields to stretch that far down again? The overnight rate is about 0.75% higher than it was in July. The Federal Funds Overnight Target-Rate is up to 1.0%-1.25% from 0.25%-0.50%.
Investors, today, looking to escape risk can do so in shorter maturity Treasuries while earning much higher yields than they could last year when the 10-year got down to 1.37%.
The tightest spread between the 10-year and the 1-year happened subsequent to the Brexit vote: 0.89%. It is currently 0.92%.
In order for you to get the previously mentioned 7% upside or price appreciation in your position in 10-year Treasuries (as yields set a new all time low), it appears a serious reversal in short term rates will also have to happen and/or a dramatic flattening of the yield curve will have taken place, reducing the 10-year/1-year spread to a new low.
Buying put options is also diversifying. However, put options are generally priced such that one expects a negative return over time from the premium. It is the cost of this insurance you get from puts, relative to the benefit why the Finance professors are less excited about them for diversifying your portfolio.
Muzzled upside potential:
Treasuries have an important negative correlation with equities. Unfortunately, given those recent rate hikes the upside appears limited at their 2.1% current yield, at least in the short- to medium term. Meanwhile, the chance for that upside now requires a net carrying cost, or negative expected real profit, much like buying put options: no more “free lunch”.
How about that downside risk?
If the 10-yr yield were to creep back up 2.6%, as was the case last March, you will have lost approx. 4.5% of market value. And if rates continue to 3%+, as in 2014, and on the model of many forecasters, that reflects a nearly 8% drop in value or the price.
Liquidity is important, as the ’08 crisis made clear, however, this is less critical for an individual investor with a properly constructed long-term investment portfolio. And it certainly is not a stand-alone argument for holding 10-year Treasuries. There are plenty of other ways to have some liquidity in one’s portfolio without the additional downside risk noted above.
If anything, this “feature” of Treasuries, prevents their yield from being higher.
Safety and liquidity are essentially why yields are so low right now. U.S. Treasuries of all forms and maturities make for a great store of value: they are a great place to park your capital.
SIDE COMMENT: Goal #1 is to take reasonable measures to avoid losing value. #2 is to outpace inflation and #3 is to generate a positive real return. At some point, the significant and growing pools of parked capital need to be reallocated to meet goals #2 and #3.
Much like the flight to safety in Treasuries today drove prices up and yields down, there has an unprecedented build-up of cash in the U.S. (source: St. Louis Fed). At some point, the excess cash in bank accounts and CDs will need to leave the parking lot.
What about other bonds?
The pricing of 10-yr Treasuries flows directly into the pricing of many other bonds with multi-year maturities. Which is to say negative real yields in Treasuries will hold down yields in non-Treasuries.
You can think of the yield from a longer-dated corporate bond ©, simplifying down to that of (a) 10-year Treasury or similar maturity + (b) an additional spread or premium for the credit default risk unique to that security. As such, the negative correlation to be expected from this bond comes from its (a) 10-yr Treasury characteristics and not from (b). Credit default risk is indeed positively correlated with equities, or when stocks go down, bonds with credit default risk tend to go down as well.
For example, the current yield on Apple’s bonds is a mere 2.4%.
Roughly speaking you get (a) the 5-year Treasury yield of ~1.7% + (b) ~0.7% of credit default risk, etc. If Apple CEO, Tim Cook were invested in these bonds today, he should expect to yield, after his federal and state taxes, less than 1.2%, over the next 5.7 years, well below inflation expectations.
The yield on 5-year treasuries is so low that you simply cannot expect much more of a premium yield for adding some top quality issuer-specific risk, etc. Needless to say, if he were a client, this is an example of a bond that would not be in his investment portfolio.
The flagship benchmark or index for U.S. investment grade bonds is the Bloomberg Barclays US Aggregate Bond Index. Its current yield is also 2.4%.
As of July 2017, the duration of that benchmark is up to 6.0 years vs. a 30-year average of 4.8 years.
A well-constructed investment portfolio needs to take in to account current expected real returns and not robotically follow outdated, and thus unrealistic, portfolio allocation assumptions from a different era.
You can achieve diversification — without having to include assets with negative real expected returns — but your advisor will need to look beyond the above-mentioned bonds to do so.
For example, a zero-correlation alternative with a positive real expected return after taxes can make for a superior long-term position than today’s negative-returning 10-year Treasury offering only limited upside/protection.
About the Author
Jason R. Escamilla, CFA is CEO of ImpactAdvisor LLC, a boutique Registered Investment Advisor based in San Francisco, serving individuals and corporate clients with advanced wealth management needs: high tax-bracket, custom-tailored portfolios, alternative investments, etc.
ImpactAdvisor LLC specializes in Modern Investing: Tax Smart + Socially-Selective℠
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