There’s increasing reason to believe that the Treasury market has stabilized on the fundamentals—until the next panic when the Federal Reserve again begins to talk as if a decision to taper off its program of buying $85 billion a month in Treasuries and mortgage-backed assets is just around the corner.
And if the Treasury market has stabilized, it means that the weakness in dividend stocks (calling it a sell off would be an overstatement) is at an end—for a while—too.
The latest piece of evidence comes from a Wall Street formula called the term premium, which measures the risk of holding long-term bonds by factoring in the market’s outlooks on inflation and economic growth.
If you assume that consumer inflation will continue for the rest of 2013 at something like the current low rate–the lowest rate since 2009; and if you assume that U.S. economic growth will stumble ahead for the rest of 2013 by something like 2% or so rather than “racing” ahead at 3%, then the current 10-year Treasury yield of 2.54% is about right.
The long-term reading on the term premium has been an average reading of 0.40% in the decade before the financial crisis in 2007. It’s now at 0.46%, according to Bloomberg. As recently as May 2013 the term premium was a negative 0.5%. The term premium has been in negative territory since October 2011 and turned positive only in June 2013.
What does all that mean? The term premium is the extra yield that investors require before they will buy a long-term bond instead of a series of short-term bonds. If, for example, the yield on a 10-year Treasury were 5.5% and holding a series of 1-year Treasury bills over the next 10 years would be expected to yield 5%, then the term premium would be 0.5 percentage points or 50 basis points.
In most periods you’d expect the term premium to be positive since investors would, normally, require extra yield to induce them to hold a longer-term bond. But under some circumstances the term premium would be negative. If, for example, investors wanted to lock in a long term yield instead of taking on the risk of rolling over shorter term bills—with the chance that interest rates might be lower on each subsequent roll over—then the term premium could well be negative. That is indeed why the term premium was negative in early 2013—bond buyers actually preferred locking up their money for the long term instead of taking the risk that short-term interest rates might fall for subsequent rollovers. It wasn’t necessarily that yields on 10-year Treasuries were so attractive in comparison to short-term yields. It’s just that they were preferable given the assumed unpredictability in short-term yields. Predictability is a valuable commodity for pension funds and insurance companies that want to match the timing of their cash outflows and the timing of their cash inflows.
The big reason that bond buyers have started to see 10-year Treasury bonds as fundamentally attractive again—aside from their big recent drop in price and rise in yields—is the absence of any signs of inflation. Look around the globe—can’t find it. Can’t even find a scenario that might produce it relatively soon. At current economic growth rates, the global economy is awash in capacity whether it’s capacity for manufactured goods or production capacity for commodities. With China’s economy slowing that global overcapacity doesn’t look likely to go away quickly. (The one exception to this pattern of modest inflation is, perhaps, food commodities but even there the potential for a record harvest this year has pushed down near-term prices.)
Real yield on the 10-year Treasury—that is the yield once you subtract current inflation—is 1.56 percentage points, the highest level since March 2011. As recently as November, real yields were negative.
This hasn’t been a great first half for Treasuries and other bonds. Treasuries, according to the Bank of America Merrill Lynch bond index, lost 2.48% in the first half of 2013, the biggest loss since 2009
But Wall Street now believes that bond prices have stabilized within a likely range for the 10-year Treasury of 2.4% to 2.8% for the rest of 2013. High levels of bond market volatility and the uncertainty over when the Fed might begin The Taper argue that bonds yields aren’t going back to former lows, however.
What does this mean to you?
First, that it’s reasonably safe to invest in bonds again—though I’d protect my portfolio by buying individual bonds rather than a bond fund. Individual bonds mature so that even in a falling market for bonds, you get your original capital back (assuming that you didn’t buy at a premium to par) when your bond matures. Bond funds never mature; their portfolios just keep rolling over as holdings mature or are sold. If the bond market has indeed stabilized, then you might even be looking at outperformance from higher risk categories. But I’m not a bond guy and I couldn’t begin to point you to specific parts of the higher-risk market.
Second, that if the bond market has stabilized, it might mean less money is available to move from bonds to stocks. It’s not clear that the great rotation toward stocks and out of bonds was ever more than wishful thinking by equity guys, but more stability in the bond market does lower incentives to make the switch.
Third, this isn’t to say that stability in the bond market is a net minus for stocks. Anything that lowers investor fear helps all asset prices since the first step in a time of perceived crisis isn’t into a different asset class but into cash and onto the sidelines. Less scary volatility in bonds reduces the impulse to sit the whole thing—bonds and stocks—out.
Fourth, dividend stocks didn’t take anywhere near the punishment that bonds received, but they did inch back a bit and I’ve sensed a growing reluctance to invest in the category with every twitch of the bond market sell off. A dividend stock ETF like the extremely low-cost Vanguard High Dividend Yield Index ETF (VYM), dropped 0.13% in June. That’s only big news in the context of the fund’s one-year return of 25.98%. Other dividend ETFs show the same pattern—the WisdomTree Total Dividend ETF (DTD), for example, was down 0.59% in June. Some individual dividend stocks show what I’d call a similar trend—General Electric was down 0.56% in June—although it’s hard to separate industry factors from dividend effects.
The place I might look for the biggest boost from a return to normal by the term premium is in the master limited partnership space. These partnerships depend on cheap short-term money—and the stability of short-term rates seems to be secure for an extended time according to the Federal Reserve—and a belief that long-term real yields will be well above those short-term rates.
The return of a positive term premium suggests that belief in those two conditions has returned to the market. I’ll try to make a few specific MLP suggestions in the next day or two. In the meantime you might take a look at the MLPs in my Dividend Income portfolio http://jubakpicks.com/jubak-dividend-income-portfolio/
Full disclosure: I don’t own shares of any of the companies mentioned in this post in my personal portfolio. When in 2010 I started the mutual fund I manage, Jubak Global Equity Fund http://jubakfund.com/ , I liquidated all my individual stock holdings and put the money into the fund. The fund did not own shares of any stock mentioned in this post as of the end of March. For a full list of the stocks in the fund as of the end of March see the fund’s portfolio at http://jubakfund.com/about-the-fund/holdings/
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