At the start of 2010, one of the most “obvious” predictions among the financial wizards was that interest rates would rise, pushing down bond prices.  In perhaps the boldest comment we’ve read, Nassim Taleb (author of “The Black Swan”) said that “every single human being” should bet that U.S. Treasury bonds would decline in value due to the certainty of rising interest rates.

So far, so wrong.

Instead of skyrocketing, U.S. Treasury yields have tumbled.  The 30-year rate has dropped from 4.64% to as low as 3.55%.  This has resulted in a substantial increase in U.S. Treasury bond prices.  Far from disaster, the 20+% returns on long-term Treasuries in 2010 are one of the few places investors have done well.

Our stance is that long-term U.S. Treasury bonds serve a specific role in defending against deflation.  We don’t believe any other assets can perform this role to the same degree.  Thus, even though the risk exists that interest rates will rise and Treasuries will do poorly at some point, we still want some exposure in the event that deflation occurs.

Now that investor sentiment has shifted toward deflation and Treasury bond prices have already increased, does it still make sense to hold onto them at lower yields?  We think it does and will demonstrate below.  However, if you follow an investment plan that has a target weight to each type of asset you own, the recent outperformance of long-term Treasury bonds may have resulted in an overweight allocation.  In that case, it may make sense to reduce your Treasury bond holdings somewhat to get back to the target.

On the surface, a 3.5% yield on a 30-year bond doesn’t look very appealing.  Looking deeper, though…well, it still doesn’t sound that great.  But there is one scenario in which you might be very glad you owned those bonds: prolonged deflation.  That is a time when the economy is seeing declining prices for goods and services and credit is contracting.  In this case, we would expect U.S. Treasury yields to continue to fall.  How far they’d fall, we don’t know for sure, but looking elsewhere in the world tells us that they can certainly go lower.  For example, 30-year German government bonds are yielding just 2.6%, while Japan government bonds are at a stunningly low 1.6% (and have been low for many years).  Those countries aren’t exactly in great fiscal shape themselves, so who’s to say that U.S. rates can’t reach those levels?

Let’s look at what could happen if a new 30-Year Treasury bond was issued with a 3.5% yield, at a price of 1,000.
 

*The estimated price assumes an instantaneous change in yield, but it is unrealistic to expect such large changes in a short period of time.  Thus, the prices shown should be considered maximum estimates given the specified change in yield.

As you can see in the far right column, there is still substantial upside potential in 30-Year Treasury bond prices in the event that interest rates continue to fall (you’ll also receive the interest, of course).  But is it really worth the risk to lock in at 3.5% for 30 years?  The important point to always consider is not how an investment performs on a standalone basis, but how it operates in the context of your entire portfolio.  If deflation strikes, it is likely that stocks and other risky assets will perform poorly.  If true, Treasuries might be the only asset class you own that are increasing in value.  And that, we think, is worthwhile.


Please note:  The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.  To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing.  All performance referenced is historical and is no guarantee of future results.  All indices are unmanaged and cannot be invested into directly.