Specialness of Long Treasuries

When Gary Schilling presented to the Baltimore CFA Society, he made the comment about how much bonds beat stocks by.  His proxy for bonds was 25-year zero coupon bonds.  Invest in those from 1980 to the present, rolling to the new 25-year regularly, and yeah you can beat stocks handily when interest rates fall and continue to fall.

Think of what a 25-year zero coupon Treasury means.  The price measures how much you are willing to discount inflation and nonexistence of the US government 25 years from now.  When interest rates fall 3% for a 25-year zero, the value of the bond more than doubles.  Falling almost 12% in yield since the peak, that multiplies the value of the bond more than 16 times, far more than the equity market over a similar period, including dividends.

But wait.  How many people would have the stomach to make such a trade even if they were mostly convinced that rates would fall so much?  Few, I think.  The more volatile the investment, the fewer the people who follow through. People lose confidence during extended slumps.  Schilling and Hoisington may have had the courage to do it, but few others did.

The same applies to a 100% equities portfolio.  Few can stomach that level of volatility.

But when one compares bonds to stocks, be careful what you allow to be the bond proxy.  Personally, I would choose the Lehman Barclays’ Aggregate — it’s a good proxy for the investment grade bond market, and there is nothing special about it — it has all risks, and an average level of interest rate sensitivity.  It has done well over the last 30 years, but has not beaten stocks.  Over the last ten years, yes, it has beaten stocks.  But that is normal.  Stocks have bad decades, every three decades or so.  In those decades, bonds often do better.

If one uses 30-year Treasuries, rolling them over the last 30 years, you end up with an incredible result. Not quite as good as 25-year zeroes, but still good enough to beat the S&P 500 with dividends.

What I am arguing is that choosing the narrow area of the bond market that did best over the last 30 years — highest quality noncallable long debt, is not a fair comparison against the stock market as a whole.  We should use the investment grade bond market as a whole, and that means the Barclays’ Aggregate [AGG].

Let me put it this way, if someone can pick the best performing index of bonds to compare against stocks, what is to keep the stock manager from picking the best sub-index of stocks to be the policy comparison?  Hindsight is 20/20, so let’s limit the comparison to broad indexes.

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About David Merkel 145 Articles

Affiliation: Finacorp Securities

David J. Merkel, CFA, FSA — From 2003-2007, I was a leading commentator at the excellent investment website RealMoney.com (http://www.RealMoney.com). Back in 2003, after several years of correspondence, James Cramer invited me to write for the site, and now I write for RealMoney on equity and bond portfolio management, macroeconomics, derivatives, quantitative strategies, insurance issues, corporate governance, etc. My specialty is looking at the interlinkages in the markets in order to understand individual markets better. I still contribute to RealMoney, but I have scaled it back because my work duties have gotten larger, and I began this blog to develop a distinct voice with a wider distribution. After one year of operation, I believe I have achieved that.

In 2008, I became the Chief Economist and Director of Research of Finacorp Securities. Until 2007, I was a senior investment analyst at Hovde Capital, responsible for analysis and valuation of investment opportunities for the FIP funds, particularly of companies in the insurance industry. I also managed the internal profit sharing and charitable endowment monies of the firm.

Prior to joining Hovde in 2003, I managed corporate bonds for Dwight Asset Management. In 1998, I joined the Mount Washington Investment Group as the Mortgage Bond and Asset Liability manager after working with Provident Mutual, AIG and Pacific Standard Life.

I hold bachelor’s and master’s degrees from Johns Hopkins University. In my spare time, I take care of our eight children with my wonderful wife Ruth.

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