Treasuries: Whither from Here?

Written by John Lounsbury

Earlier this week I posted an article at Investing Daily about the performance of the iShares Barclays 20+ Year Treasury Bond Fund (NYSE: TLT) since it first became available in September of 2002.  I remarked that the volatility had been quite adventerous for something that is perceived as a conservative investment.  Well, it may be that the ups and down for TLT have been sharp and frequent, especially during the past five years, but the deeper history of the long treasury bond (30-year maturity) has had some wild rides in the past.

The first graph is repeated from the Investing Daily article.  The price volatility of TLT is quite remarkable.

Click on graph for larger image.

But when one looks at the 35-year history of the interest rate for the 30-year treasury bond one sees some pretty wild history.

Click on graph for larger image.

On this graph the volatility looks to be even greater back in the 1980s that it has been recently.  However, the second graph above is plotted for interest rate variation and the first one is plotted for bond price variation.  There is a world of difference in how the scale of change works.  A 1% change in interest rate for a 30-year bond going from 4% to 3% produces a price increase for the previously issued 4% coupon bond about 23%.

In 1981 30-year treasuries were issued with coupons around 15%.  To get 23% increase in price for one of those bonds the interest rate would have to fall below 10%.  That 1980s’ drop would have to be more than 5% to be equivalent in bond price change to either of the two 1% interest rate declines that occurred since 2008.  One of them (1984-86) exceeds that 5% threshold while the other big decline from 1981 to 1983 just reaches the 5% amount.

The bottom line is that, contrary to appearances in the 35-year graph above, the volatility in bond prices has actually been quite similar in the past four years compared to the 1980s.

The second bottom line is that these two periods were among the most volatile for bond prices of any seen in the past century.  And therein lies a caution.  It is not uncommon that increased volatility occurs near market turning points.

The 1980s saw a massive bottom for bonds (interest rates topped).  Could the 2010s see a massive top for bonds?

The answer is yes – it could.  The follow-on question would be how soon, and therein lies a problem.

Before we address that problem, though, let’s take a deeper look at the long history of the Treasury bond market.

Times When Volatility Failed to Indicate Turning Point

The following graph is a valuable reference.

Click on graph for larger image.

There were previous times when interest rate volatility was high and no trend reversals occurred.  Note the early 1960s and the early 1970s.  Interest rates kept right on climbing, and climbing a lot.

Since 1990 there have been frequent high volatility episodes and interest rates just kept on falling.

Clearly the observation about the early 1980s volatility and trend reversal is the exception.  Other such periods have not indicated imminent reversals.

The Japanese Comparison

Japanese Treasury bonds have been rising for over 20-years the 30-year bond has recently been trading with yields in the 1.7% to 1.9% range.  The 30-year Japanese Treasury has yielded less than 3% for more than ten years.

The current yield on the U.S. 30-year bond is 2.66%.  If the U.S. continues to follow the Japan pattern and the 30-year bond gets down to a yield of 1.7%, that would be an additional gain in the vicinity of 40% for the 30-year bond.  For that to occur, it is likely there will be significant deflation occurring.  This could cause asset price deflations so other investments could be declining during such an event.

If the U.S. continues to follow the Japanese path there could still be major gains for bonds.  And they could be offsetting losses in other asset classes.

So What to Do?

It is mostly likely that the best path will keep some investments in both bonds and stocks, as well as commodities and gold.  Gold has gained less than either stocks and bonds over the past three years, but as discussed in prevous articles, here and here, it has had continuing value in reducing portfolio drawdowns.

The secret to navigating the end of this great thirty year long bull market for bonds will be to maintain diversification in portfolios and carefully manage drawdowns to prevent run away losses.  There may be 20% to 50% gains yet to come in bonds over the next few years.  Just be careful that you don’t take a 50% loss because you were holding on for the last 10%.

Related Articles

Treasuries:  A Great But Bumpy Ride by John Lounsbury (Investing Daily)

Gold’s Persistent Allure by John Lounsbury (Investing Daily)

Gold and SPY are Uncorrelated, So Good to Mix in a Portfolio, Right? by John Lounsbury (GEI Metals)