Treasuries Look Like Insurance for a Crash

Investors who expect big losses in stocks accept smaller ones on government bonds.

If this is what keeps you up at night....

Photographer: Martin Hunter/Getty Images

U.S. Treasuries offer historically low yields, with negative returns after taking taxes and inflation into account. Investors wouldn't willingly invest to earn negative returns, so why buy Treasuries? These should be considered purchases of insurance that guard against a meltdown or disastrous economic outcome. They hardly qualify as investments.

Prevailing low interest rates are a mystery to many analysts, because it is hard to fathom why investors would buy U.S. Treasuries at today’s very unattractive yields. Interest on Treasuries is taxable and most owners are in the highest federal tax bracket. So a 10-year Treasury yielding 2.3 percent provides a net return of about 1.4 percent after tax. The Fed’s inflation target is 2 percent and prevailing measures of inflation range between 1.5 percent and 2 percent and are possibly, or likely, headed higher. So, after adjusting for taxes and inflation, an investor has almost certainly locked in a negative rate of return over a 10-year horizon.

It isn't helpful to note that sovereign yields are even lower in Europe and Japan, so U.S. government bonds are highly attractive in comparison. It only deepens the mystery that foreign investors would accept even more outrageously low or more negative bond returns. Something is very much amiss. Given the negative yields on sovereign bonds overseas, it isn’t surprising that institutional European investors who shift from bonds into bank deposits to avoid losing money are charged a fee on their deposits, so they lose money either way.

Why would any investor acquire an asset that guarantees they will lose money? At the simplest level, rates are so low because the central banks want them there and have flooded the market with liquidity to achieve this end. But this explanation isn’t fully satisfactory. No one forces investors to buy. They could refuse, which would force rates higher. So, investors ultimately accept these lower yields.

Some investors find all kinds of reasons to rationalize their decision. Some point to the fact that U.S. interest rates are considerably higher than sovereign bonds issued in Europe or Japan. (My mother’s response to this would have been: If other people jump off a cliff, why should you follow?) And those foreign investors are probably unhappy with their investment decision, since they have suffered much larger currency losses recently than they have gained in incremental yield. Some reverse the argument and suggest bond yields are low because the economy is performing very poorly, so the yields are appropriate returns for the prevailing economic environment. But this view implicitly accepts the market yield as appropriate and rationalizes it, even when the data doesn't support the argument. Instead, they ignore all the macro data, including falling unemployment and rising corporate profits, or argue it fails to capture the poor state of the economy.

The real answer may be that Treasuries are an attractive investment choice when the alternative investment is at risk of even greater losses. I am reminded of some testimony given before Congress by an investor during the 1930s in response to a question why this individual bought and kept his Treasury securities after they had matured. He explained that it was the safest place he could think of to keep his money! At the time, banks were failing left and right, so this investment choice makes sense in that context. And today’s context is analogous.

Investors who think the stock market is overvalued and want a safe investment might sensibly choose to hold Treasuries since they expect to lose less money on Treasuries than in equities. (An alternative view that stocks are fairly valued is here). The losses investors expect to take on their Treasury holdings are, in effect, the premiums they are paying to own investments that will preserve as much capital as possible in an investment environment that they fear will suffer losses.

Indeed, there are a number of well-known money managers who have explicitly and publicly made the decision to reduce equity exposure or even to short parts of the equity market. They commonly point to the Schiller CAPE, or cyclically adjusted price/earnings, as justification for avoiding equities, even though, for many years, that tool has been dreadfully wrong in valuing the market or suggesting entry points. This behavior has contributed to very poor portfolio performance and large withdrawals from these funds. That so many professionals and individuals engage in this practice is a clear indication that the equity rally since 2009 may be the most hated ever, which is precisely why the market has difficulty going down. Any time it does decline, some investors sitting on cash take the opportunity to get in.

Economists normally try to use the yield curve to calculate all kinds of useful information embedded in the data, such as term premiums and expectations for future inflation. In this environment, the embedded negative returns may be more useful in estimating the size of the insurance premium investors are paying to protect their net worth. And in suggesting that investors fear stocks, what better contrary indicator can there be to imply that the equity market still has more upside?

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