Dr. H. Nejat Seyhun, contributing writer to The BusinessThinker magazine, is the Jerome B. & Eilene M. York Professor of Business Administration and professor of finance, Ross School of Business, University of Michigan. He is an internationally recognized authority on financial issues and Derivatives.
All I read these days is how much Treasuries are overpriced. At the beginning of 2011, Bill Gross, the famous bond fund manager at Pimco, predicted serious losses for Treasury investors and he publicly announced that Pimco had sold its massive Treasury positions. In addition to fund managers and newspaper columnists, recently some well-known economists have also joined this chorus. Their argument is simple and appealing: At an annual yield of 1.9%, with actual inflation running over 2%, these experts are telling everyone that expected real Treasury returns are negative and that anyone who buys Treasuries is likely to be disappointed over the next ten years or longer.
Inflation worries are certainly real. Some suggest and worry that faced with a massive and ever-increasing debt, the U.S. Government is likely to inflate even further in the future to reduce the real debt burden similarly to what it did in the 1950s by pegging the interest rates below the inflation rate. In fact, Charlie Plosser, president of the Philadelphia Fed, has also publicly expressed his inflation worry. If the Fed were to carry out such monetary policy, this would further erode the real returns to long-dated Treasuries.
The case against the Treasuries appears simple, logical and appealing, but is it correct? Are Treasuries overpriced?
In fact, 2011 turned out to be a great year for long-dated Treasury investors. The yield on 30-year Treasuries declined from 4.4% at the beginning of the year to 2.9% at the end of 2011, producing a whopping 30% plus return. Ex-post, it turned out that the long-dated Treasuries were some of the best investments of 2011. Hence, there is no evidence so far that holders of long dated Treasuries would have regretted their investment decisions.
Critics will point out that ‘post-hoc’ does not make ‘prompter-hoc.’ Furthermore, one data point does not prove anything. One can be correct ex-ante but still miss the mark ex-post.
Let’s turn to finance theory for some help. What does finance theory say about the pricing of Treasuries? Finance theory does not judge expected return in isolation. According to finance theory, even investments with expected negative returns can be attractive investment vehicles (e.g. insurance). Finance theory simply states that while expected returns matter, risk also matters. Higher risk is rewarded with higher expected return and lower risk earns lower expected return. Simple. So far, so good.
Finance theory also tells us that appropriate measure of risk means covariance risk not variance risk. This is where some of the experts who argue that Treasuries are overpriced are missing the mark.
During 2011, the long dated Treasuries have actually become less risky (in terms of their covariance risk with the stock market) as their negative correlation with the S&P 500 index has increased to -75%. In fact, during 2011, long-dated Treasuries have become excellent vehicles to reduce and substantially eliminate the risk of one’s stockholdings in an especially volatile market. This decline in covariance risk coupled with increasing market volatility made long-dated Treasuries more attractive investment vehicles, increasing the demand and price of these Treasuries and reducing their yield. There is nothing anomalous about this. All of this is consistent with financial theory.
The key insight in all of this is the following: Do not put all of your eggs in one basket. What financial theory is telling us is to hold the long-dated Treasuries as part of one’s overall diversified portfolio and not in isolation. If you put all of your wealth into Treasuries (or for that matter gold, oil or any other single investment), you are not getting the best risk-return trade-off. You are only getting 1.9% yield and missing out on its risk-management or insurance feature. You should hold Treasuries along with the stock market to get this insurance benefit.
Bottom line: Given its current strong negative correlation with the stock market, there does not seem to be anything anomalous about the pricing of the long-dated Treasuries.