Bonds: Reversion Cuts Both Ways

Friday, April 24th, 2009

Robert Arnott, Founder, Research Affiliates, and innovator of FTSE-RAFI Fundamental Indices, has published a detailed report testing the question of why investors should bother holding bonds (at all?) and displacing the long-standing notion that stocks for the long run hold a 5-percent risk premium over bonds. This is a must-read-over-the-weekend report as it is lengthy, but far from boring.

Here is a preview:

“Reversion cuts both ways,” according to Arnott.

For four decades, from time to time, we hear this question: Why bother with bonds at all? Bond skeptics generally point out that stocks have beaten bonds by 5 percentage points a year for many decades, and that stock returns mean-revert, so that the true long-term investor enjoys that higher return with little additional risks in 20-year and longer annualized returns.

Recent events provide a powerful reminder that the risk premium is unreliable and that mean reversion cuts both ways; indeed, those 5 percent excess returns, earned in the auspicious circumstances of rising price-to-earnings ratios and rising bond yields, are a fast-fading memory, to which too many investors cling, in the face of starkly contradictory evidence. Most observers, whether bond skeptics or advocates, would be shocked to learn that the 40-year excess return for stocks, relative to holding and rolling ordinary 20-year Treasury bonds, is not even zero.

The Death Of The Risk Premium?

It’s now well-known that stocks have produced negative returns for just over a decade. Real returns for capitalization-weighted U.S. indexes, like the S&P 500 Index, are now negative over any span starting 1997 or later. People fret about our “lost decade” for stocks, with good reason, but they underestimate the carnage. Even this simple real return analysis ignores our opportunity cost. Starting any time we choose from 1979 through 2008, the investor in 20-year Treasuries (consistently rolling to the nearest 20-year bond and reinvesting income) beats the S&P 500 investor. In fact, from the end of February 1969 through February 2009, despite the grim bond collapse of the 1970s, our 20-year bond investors win by a nose. We’re now looking at a lost 40 years!

Stocks have done better, but not in the last 40 years…

It’s hard to imagine that bonds could ever have outpaced stocks for 40 years, but there is precedent. Figure 1 shows the wealth of a stock investor, relative to a bond investor. From 1802 to February 2009, the line rises nearly 150-fold. This doesn’t mean that the stock investor profited 150-fold over the past 200 years. Stocks actually did far better than that, giving us about 4 million times our money in 207 years. But bonds gave us 27,000 times our money over the same span. So, the investor holding a broad U.S. stock market portfolio was 150 times wealthier than an investor holding U.S. bonds over this 207-year span. So far, so good.

That 150-fold relative wealth works out to a 2.5-percentage-point-per-year advantage for the stock market investor, almost exactly matching the historical average ex ante expected risk premium that Peter Bernstein and I derived in 2002 in “What Risk Premium Is ‘Normal’?” Those who expect a 5 percent risk premium from their stock market investments, relative to bonds, either haven’t studied enough market history—a charitable interpretation—or have forgotten some basic arithmetic—a less charitable view.

A 2.5 percentage point advantage over two centuries compounds mightily over time. But it’s a thin enough differential that it gives us a heck of a ride.

• From 1803 to 1857, stocks floundered, giving the equity investor one-third of the wealth of the bond holder; by 1871, that shortfall was finally recovered. Oh, by the way, there was a bit of a war—or three—in between. Forget relative wealth if you owned Confederate States of America stocks or bonds. Most observers would be shocked to learn that there was ever a 68-year span with no excess return for stocks over bonds.
• Stocks continued their bumpy ride, delivering impressive returns for investors, over and above the returns available in bonds, from 1857 until 1929. This 72-year span was long enough to lull new generations of investors into wondering “why bother with bonds?” Which brings us to 1929.
• The crash of 1929–32 reminded us, once again, that stocks can hurt us, especially if our starting point involves dividend yields of less than 3 percent and P/E ratios north of 20x. It took 20 years for the stock market investor to loft past the bond investor again, and to achieve new relative-wealth peaks.
• Then again, between 1932 and 2000, we experienced another 68-year span in which stocks beat bonds reasonably relentlessly, and we were again persuaded that, for the long-term investor, stocks are the preferred low-risk investment. Indeed, stocks were seen as so very low risk that we tolerated a 1 percent yield on stocks, at a time when bond yields were 6 percent and even TIPS yields were north of 4 percent.
• From the peak in 2000 to year-end 2008, the equity investor lost nearly three-fourths of his or her wealth, relative to the investor in long Treasuries.

This is an in-depth analysis and worthy of a back to back read, from one of the industry’s pre-eminent philosophers, as well as the innovator of FTSE-RAFI Fundamental Indexes.

The full report can be read and printed here.

Tags: Bond Yields, Capitalization, Carnage, Contradictory Evidence, Excess Return, Excess Returns, Ftse Rafi, Good Reason, Innovator, Observers, Opportunity Cost, Percentage Points, Premium Bonds, Research Affiliates, Risk Premium, Robert Arnott, Skeptics, Stock Returns, Stocks Bonds, Term Investor, Treasuries, Treasury Bonds
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10-Yr Treasury Yields: Higher or Lower?

Friday, April 24th, 2009

Econompic Data looks at the possible direction for 10-Year Treasurys. On one hand you have the supply issue; on the other hand you have deflation and further deterioration, combined with the Fed’s impetus to purchase lond-dated treasurys which could drive yields down further:

Higher –> Supply: Across the Curve

Treasury bonds are taking a severe drubbing and the yield on the benchmark 10 year note is approximately at the level which prevailed on the day when the Federal Reserve announced quantitative ease (2.96 percent currently).

One participant noted that the 200 day moving average on the Long Bond was 3.798 percent and the market penetrated that level this morning as a sharp knife would melting butter.

The yield curve has steepened sharply and participants are deeming the belly of the curve particularly odious. The 2year/10 year is once again close to 200 basis points and the 2year/5year/30 year butterfly has returned to 93 basis points after a foray into the low 100s.

Dealers report rate lock selling and fear of very heavy Treasury supply next week. As I have mentioned too often the Treasury will announce around $ 100 billion of new supply tomorrow. It will consist of 2year,5 year and 7 year notes.

Lower –> Quantitative Easing / Continued Economic Deterioration: Zero Hedge

n light of next week’s scheduled meeting of the Fed, we thought we would look at the potential for further announced quantitative easing. Last month, the Fed rocked most major markets with the announcement of a major purchase of long rates to push down yields. Since then, many have dismissed the purchases as a one-time event that are not likely to repeat. However we have to question that thinking as it is very much in line with the pre-crisis mentality that quantitative easing is the equivalent of a nuclear bomb in a central bank’s arsenal and the unpredictability of any resulting inflation would destroy all credibility that a central bank may have to price stability.

There has been a lot of criticism of Big Ben (us included) but one thing that has come out is he is not afraid to take relatively risky moves to combat whatever he perceives as the biggest threat. As we have noted before, he has clearly revealed his playbook in the past and we see little indication that he will stray from it going forward. On the balance between inflation and deflation, much has been made of the Chinese response if we try to print our way out of this situation but the much larger problem has always been deflation. Combining what we know about the available policy options and the effectiveness of the last round of QE, we have to believe that more purchases of long rates are on the table as a serious consideration.

We are not saying that the Fed is deaf to the concerns of price stability; indeed, the specific concern is addressed in last month’s minutes.

Also, some participants were concerned that Federal Reserve purchases of longer-term Treasury securities might be seen as an indication that the Federal Reserve was responding to a fiscal objective rather than its statutory mandate, thus reducing the Federal Reserve’s credibility regarding long-run price stability. Most participants, however, saw this risk as low so long as the Federal Reserve was clear about the importance of its long-term price stability objective and demonstrated a commitment to take the necessary steps in the future to achieve its objectives.

However, consumer spreads continue to stay at high levels.

Additionally, long rates have given back much of the gains made from the time of the previous announcement.

In light of the minimal impact of the announced $300B bond purchase last month, we have to think that the Fed will give it at least one more go. The Fed can really only directly control the benchmark - if the Treasury figures out a way to strong arm banks into flowing credit again, that may put a stop to further QE but that isn’t a likely scenario in the short-term.

At this point the issue of deflationary pressure does seem to be the 800-pound gorilla in the room.

Source: Yahoo

Tags: 10 Yr Treasury, Basis Points, Credibility, Crisis Mentality, Drubbing, Economic Deterioration, Federal Reserve, Foray, Impetus, Lond, Moving Average, Nuclear Bomb, Price Stability, Sharp Knife, Time Event, Treasury Bonds, Treasury Yields, Treasurys, Unpredictability, Yield Curve
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