It is very much taken for granted that bonds, and especially treasuries, are quite a bit less risky than stocks. This isn’t quite accurate, and it’s a lot less accurate these days.
U.S. treasuries are considered so low risk that we even call them risk-free. Nothing is absolutely risk-free but the chances of these securities defaulting are right up there with the chances of an apocalypse, as this is just about what it would take to bring down the U.S. Treasury currently.
There will be a day of reckoning, where the sheer mass of the U.S. debt will simply collapse under its own weight, but this time is many years away and as long as people are willing to buy more treasuries, the U.S. can just keep borrowing more and more.
When we think of the risk involved in debt instruments like treasuries, we naturally think of default risk, but default risk is only part of the risk involved in holding this paper. Those who hold a more sophisticated view of them will always point out that one of the big risks with bonds is interest rate risk, but that’s not the end of the story at all as there is another risk that needs to be accounted for, which is price risk.
If we always just held bonds to maturity, then default risk plus interest rate risk would at least seem to define our total risk, as when we do this, we just pay whatever price the bonds cost and redeem them for their face value when the term is up.
Most treasuries are not held to maturity by the purchaser though, especially the longer ones. This is especially true today with bond funds doing so much volume, and bond funds will not generally hold bonds to maturity, and there’s a good reason why they don’t actually.
With the 30-year treasury bond now at 2%, some have started to wonder whether they would not be better off investing in stocks given that the yield on the average stock in the S&P 500 is right around this, and with stocks you get the opportunity for much more capital growth, because this is the primary benefit of stock investing.
We could very reasonably project a total net return with stocks of 7% per year, which takes the average price growth plus dividends minus inflation, which we can assume to be 3%. This inflation number is well below historical levels but is a number in accordance with what we could call the 21st century economy, which is managed more tightly and efficiently than in the past.
One of the big reasons why we can manage inflation so much better is that the frontier days are over and while there is still good potential for economic growth, we will be seeing more modest levels due to the degree of economic saturation that we now have.
If we use the same formula with our 2% yielding 30-year treasury, we end up with a net loss of 1% per year, which cashes out to a loss of 30% overall versus the 210% net gain with stocks, for a net difference of 240% over the 30 years.
Making More Money More Safely is Always the Better Play
The fact that this is not the time to buy and hold treasuries isn’t lost on very many people, and many are complaining that this strategy just isn’t a good one right now given the low yields out there. It’s actually not a very good one period, because when yields are higher, so is inflation, and this is like savings account rates which at best look to recover losses to inflation and hopefully you’ll end up making nothing really over this time, basically lending your money to the government interest-free.
The 210% net gain with stocks over this time is probably on the lower end of what is achievable, especially when we look back over the last 30 years and see a 1000% gain, which works out to 33% per year on average plus dividends. Sure, inflation has been higher during this time than it is now, but this still leaves us with a massive advantage over what we could have achieved by investing in treasuries.
When comparing the two strategies over the next 30 years, we first need to realize that treasuries do have some real risk, the risk of losing money on a net basis. This risk is particularly high now given that the yields are so low. Inflation is very unlikely to stay below 2% for very long, and if the average rate of inflation is greater than this, and you’re only getting a yield of 2%, this means that you are likely and even very likely to lose money as far as the purchasing power of your investment goes.
This definitely qualifies as risk, because that’s what risk is with securities, the risk of losing money. It might be simpler to just ignore inflation and say we’ll make 2% times 30, but that would be a completely distorted view of what really happens.
Stocks, on the other hand, could in theory not cover the rate of inflation over a 30-year period, but this is very unlikely. On this strategy, where we hold both for 30 years, treasuries are clearly the riskier investment, and this does not even count comparative risk.
Comparative risk takes into account opportunity cost and looks at both the potential to lose money on a nominal basis, to have your investment worth less in the end, as well as the risk that you will end up with less with your investment versus another. In this case, the gap between treasuries and stocks is a huge one.
The key to this is the long timeframe though, and if we did this with a one-year timeframe, the situation may appear to be different, and we would think that treasuries would easily be the less risky of the two. Treasuries will always come out way behind on a long-term risk calculation, but their claim to fame is less volatility, so to suggest that treasuries are riskier than stocks over this short duration would at least seem to be much more difficult to demonstrate.
If you had to invest in either stocks or treasuries for a year and then close your position, and all you were concerned about is getting your money back, it might seem odd to think that stocks will be less risky, but in some cases, like right now, they actually are.
The Risk that Treasuries Will Trade Lower in a Year is Very High
We can start by looking at the chances that our bond position and our stock position would be behind in a year. We know that this can happen with stocks, but with our current market, we still are in a bull market, and while this doesn’t mean that we can count on a positive net return, stocks are ripe to put some sort of gain in over the next 12 months.
Treasuries are a different story though. Their prices have been run up to historic levels, to a point where the downside is clearly bigger than the upside. Treasuries are still very much tradeable at these levels, as they could go higher, but to do this sensibly we need to have a keen eye to know when the party is ending and get out. Holding them for a year takes us well beyond that.
The yield that you get over this time with the bonds will be right around where inflation is, so whether we win or lose depends on where your chosen treasury will be trading in a year from now when you will be selling it. It is actually very likely that they will be trading at a lower price in a year, and this is much more likely than stocks trading at lower prices in a year.
People might accept this but think that the extent of the risk with treasuries is less, because we are all too aware of how much more volatile stocks are normally. The key word here is normally though and we’re at a point far away from normal when it comes to bonds.
In 2018, we suffered the first real bear market with stocks since the crash of 2008-09, where they fell by 20%. This is the minimum standard for a bear market and we didn’t stay down there for very long, but this is one recent enough that just about everyone will remember it.
This was ultimately caused by the Fed overdoing interest rate hikes, and we’re in the opposite place now, where they are risking doing too much the other way if anything nowadays. The stock market has taken a lot of punishment this year with concerns but it has held up and the biggest reason is that the Fed is on our side now so to speak.
On the other hand, if the yield on the 30-year climbed from 2% to 3%, which is much more likely than seeing stocks dive as much as they did late last year, buying them here and selling at the lower prices that this move in yields would produce would see us lose this very amount, 20%.
While the new dovish approach by the Fed will keep a lid on this somewhat, treasuries are very much overbought these days and it wouldn’t take all that much to send treasuries sinking in price by this much. We saw 10 basis points added to the yield on Friday, and 100 basis points is a full percentage, and this was just one day with trade front news very mildly positive.
We can only imagine what would happen if the two countries ended up shaking hands during our year of holding our treasuries, but we may be quite lucky in that case to just walk away with a 20% loss. The yield on the 30-year was as high as 3.4% less than a year ago, and could go back to that level or even higher even without anything near this dramatic happening.
If we do seek out less risk, then we cannot automatically just assume that treasuries, having virtually zero default risk and paying out fixed rates of interest over time, is the least risky path in all cases. Sometimes it is not, and we cannot ignore the treasury market and where it may be headed without risking painful mistakes due to a real misunderstanding of what exactly we are buying.
Risk management involves looking at risk from all sides, not just one, as the risks that we don’t account for can certainly come back to bite us and bite us pretty hard at times. Treasuries are simply very risky right now with any strategy, and unless we are prepared and able to effectively ride shotgun with our treasury positions and jump off the wagon before it leaves the trail and ends up on its side, which very few investors are capable of, we’re better off riding the stock trail instead.