The days of long-term Treasury bonds delivering stock-like total returns are probably behind us — even if yields drop significantly from here. The problem isn’t one of economic fundamentals, but rather mathematics. For investors, this means it’s time to avoid the Treasury-based ETFs and look instead to high-yield bonds.
Here’s why: With the yield on the 10-year Treasury at 1.96% and its “duration” sitting at 8.9, the room for upside is extremely limited. Duration, a measure of interest rate sensitivity, can be used to calculate the approximate return of a bond with a one-percentage point change in yield.
So, even if the 10-year Treasury were to plunge to 1.25% — the most-frequently cited target by those who are bearish on the world economy — the price movement would only be a gain of 6.3%.* Even with the 2% yield, anyone who puts money into the 10-year today could expect a total annual return of 8.3% (6.3% price appreciation plus the 1.96% yield) in the best-case scenario.
This indicates that 10-year Treasuries are no longer an effective hedge against a disaster in Europe or another calamity for the global economy.
It’s true that we’re unlikely see the revival in growth and massive recovery in risk appetites that it would take to generate substantial losses in the 10-year. Still, the lack of any upside on these bonds’ potential shows an extremely unfavorable risk-reward profile here. The upshot: avoid the iShares Trust Barclays 7-10 Year Treasury Bond Fund (NYSE:IEF) or any other popular ETF that invests in Treasuries of 10 years or less.
The 30-year bond still has more upside potential of any spot on the Treasury curve. With a yield of 3.02% and a duration of 19.3, the 30-year has room for a gain of about 21% if its yield were to fall by the equivalent of a decline in the 10-year to 1.25%. This would indicate that there’s still an opportunity in the iShares Trust Barclays 20+ Year Treasury Bond Fund (NYSE:TLT), which has a duration of 16.8.
All of this helps makes the case for high-yield bonds. The two major high-yield ETFs, SPDR Barclays Capital High Yield Bond ETF (NYSE:JNK) and iShares iBoxx $ High Yield Corporate Bond Fund (NYSE:HYG) have yields of 6.8% and 7.2%, respectively. At these levels, high-yields are competitive with the best-case scenario for the 10-year Treasury (the gain of 8.3%), even if they experienced zero price appreciation in 2012.
High-yield remains vulnerable if Europe falls apart and investors stage another flight to safety. Still, yields are already pricing in an elevated level of fear in the market. Over time, yields generally track default rates in the high-yield sector, but right now yields in the 7% range are well above the projected 1.8% default rate in 2012.
This indicates that if the macroeconomic outlook improves in the year ahead, spreads in high-yield have room to fall — which means additional price appreciation on top of the 7% yield. In short, the risk- reward trade-off in high-yield is much more favorable than it is in Treasuries at this point.
Treasuries aren’t the only investment to move to nosebleed levels amid investors’ quest for relatively safe yield. In equities, too, sectors such as tobacco and utilities have climbed to the high end of their historic valuation — reflecting investors’ willingness to pay virtually any price for the 4%-5% yields available in these areas.
The bottom line: Instead of playing chase in any of these expensive areas of the market, consider the higher income and potential upside of high-yield bonds.
*(1.96 – 1.25) x 8.9 = 6.3% return
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