Long Bonds Are for Fools

Guest Assets Would you exchange $100,000 for a promise to receive $143,371 in April 2050? The question is rhetorical: Your answer is "No." No matter how reputable the counterparty, 30 years is a very long time to wait, and a 43% cumulative gain is a meager return for your very large expenditure of patience.

Such is the deal presented by 30-year Treasury bonds, which yielded 1.18% at the time of writing. If one were required to hold such bonds until their maturity dates, the Treasury Department’s offer would be firmly rejected. Few, if any, would accept a nominal return of slightly more than 1% in exchange for accepting the risk that inflation would not be entirely dormant throughout the next 30 years.

The upshot: Today’s investors are buying long bonds with the thought of trading them later. They are not planning on a specific date; on the contrary, they probably intend to hold those bonds indefinitely, as a proportion of their strategic asset allocation. But the possibility of exit is in the back of their minds. Otherwise, they wouldn’t have agreed to the transaction.

That makes long Treasures a different purchase from equities, where the opposite tends to apply. Stocks haven’t rallied over the past month because investors are hoping to turn quick profits by trading their equities, nor because they are excited about next year’s earnings reports. The attraction is stocks’ long-term prospects. Hold those new positions for 30 years? Sure. That, in fact, is the plan for many equity shareholders.

At today’s prices, long bonds are a fool’s purchase, to be re-sold to greater fools. That statement does not necessarily signal my disapproval. Many winning investments are bought to be traded rather than held. For example, the “momentum” strategy, which acquires securities solely because their prices have risen, then flips them when their prices start to wane, is among the most time-honored and successful of investment approaches. Far be it from me to object.

Also, there are valid reasons to believe that long-bond yields may remain low for the foreseeable future.

Constant Demand Because the U.S. dollar serves as the global reserve currency, Treasuries attract buyers who possess U.S. bonds because they must. If Treasuries pay high yields, great. But if not, those institutions will own them anyway--and in a very big way. Foreign central banks hold 40% of all outstanding Treasuries.

In addition, points out Morningstar's Eric Jacobson, institutional investment managers often employ long bonds to increase their portfolio's interest-rate sensitivity (that is, its duration). They could--and often do--accomplish the same task by using derivatives, but sometimes they prefer to hold the security directly. They, too, are not terribly concerned about the bond's yield.

Controlled Supply Naturally, the U.S. government would prefer that Treasuries command high rather than low prices. It possesses considerable power to achieve that goal. For one, it controls the bond auctions. If there appears to be too much supply for a given date on the yield curve, it can avoid selling such bonds for the time being, until the demand reappears.

For another, the Federal Reserve can actively shrink supply, should it feel necessary, by purchasing existing bonds. Writes Joachim Fels of Pimco, "central banks will likely ... cap intermediate and longer-term bond yields via large-scale purchases and/or more direct forms of yield control." He cites the Federal Reserve's activities following World War II, which effectively kept long-term Treasury yields from exceeding 2.5%.

Asset Inflation? Investment managers speak quietly rather than loudly about the possibility that today's asset prices have been inflated by the actions of central banks. That thesis is generally associated with the Austrian school of economics, which isn't a mainstream belief. Also, the contention is very difficult to verify because one cannot directly track money's movements. The conclusions are suppositions.

However, that which resists proof also resists disproof. One cannot state with certainty that the many trillions of dollars (and other currencies) created by the globe’s central banks have not led to unintended consequences. Perhaps all that cash has pushed asset prices above what they otherwise would be. Perhaps that process will continue.

Fundamentally Unsound By this point, Ben Graham would be holding his head because none of the reasons I have provided for owning long Treasury bonds involve their intrinsic value. They are instead arguments about market structure--claims for why those who don't care about intrinsic value will buy Treasuries, or for how the Federal Reserve will manipulate sales, or for the rising tide of asset inflation lifting all boats. Graham never advocated securities for those reasons. Nor Jack Bogle, nor Warren Buffett, nor any other fundamental investor who ever lived.

That's fine. You need not invest as they would wish, nor need I. (Indeed, my recent trade already had Graham and Bogle spinning in their graves and Buffett wondering why one of Berkshire Hathaway's shareholders is such a buffoon.) This column wasn't written to dissuade long-Treasury investors. Its intent, instead, is to make explicit the grounds for owning such securities--either for noneconomic reasons or for generating a trading profit.

Better Long Than Short Although I wouldn't hold long Treasuries myself--cash works just fine for safe assets, thanks much--I would prefer doing that to shorting them. Consider the sad tale of Franklin Templeton's Michael Hasenstab, who recently removed his short positions on U.S. Treasuries in Templeton Global Bond TPINX. Hasenstab's justification to short Treasuries was fundamental: Low yields belied high and rising budget deficits. Logical, no? But the tactic cost Templeton Global Bond dearly in 2019, when it finished a whopping 600 basis points behind its category average.

When value investors challenge market forces, with no imminent signs that conditions will change, value investors are usually the first to blink.

John Rekenthaler (john.rekenthaler@morningstar.com) has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.