Treasurys: Returns and Inflation
The returns on 20-year U.S. Treasurys have been amazing over the past decade (2002-2011) and over the past 30 years (11.03% vs. 0.05% for the S&P 500). This marks the first time that over any given 30-year period, Treasurys outperformed the S&P. For 2011, these long-term bonds had a total return of 28%; for 2008 the total return was 26%. These Treasurys have not seen a better year since 1995. Long-, medium-, and short-term Treasurys all had modest total returns for 2012.
At the beginning of 2011, the yield was 3.3%; by the end of 2011 it was 1.9%. To match 2011 returns, the 10-year note’s yield would have to drop to 1.05%. Over the past 50 years, the record low for 10-year Treasurys was 1.7% (September 2011). The surprise about Treasurys is how they fare compared to inflation. For example, inflation was ~ 3.4% for 2011. If someone bought a 10-year Treasury at the beginning of 2012 and held it to maturity, adjusted for inflation, the investor would lose ~ 1.5% annually—and this does not include the impact of taxes.
As of February 2013, 10-year Treasurys were yielding 1.9%.
Treasury yields can stay below inflation for extended periods. From 1942 through 1951, the Treasury Department “forced” the Federal Reserve to keep 10-year rates below 3% as the country sought to pay off its massive WWII debt. During this period, investors of 5-year Treasurys lost 4.5% each year after adjusting for inflation (worse if income taxes are factored in). Analysts generally agree that the Fed’s massive rounds of quantitative easing are keeping rates artificially low.
Alternative Considerations
As of early January 2012, 3-month Treasury bills were yielding 0.02% while a 1-year bank CD was paying 0.8%. FDIC bank money market funds were yielding 0.4% while mutual fund money market accounts were offering 0.02% (source: iMoneyNet). During the middle of the 2008 financial crisis, Warren Buffet sold $5 million of T-bills maturing in four months for $5,000,090.70, meaning the buyer was willing to lose $90.70 over four months (to ensure he did not lose even more in something else).
I Series savings bonds are an often overlooked alternative to Treasurys. These government-backed securities had a 3.06% composite yield (0% fixed rate + inflation rate) at the beginning of 2012. I Series bonds offer a number of features:
- interest payments are adjusted for inflation every 6 months
- investors can hold them for up to 30 years
- taxation of interest can be delayed until maturity or sold by the investor
- interest payments, when paid, are not subject to state income taxes
- redemption is possible at any time after a 12-month minimum holding period
- if the holding period is < 5 years, investor will forfeit 3 months of interest
- interest accrues daily and is compounded semi-annually
- interest rates are determined each May 1st and November 1st
TIPS
A more traditional alternative to Treasurys are TIPS, inflation-adjusted government securities. TIPS pay a stated return (currently 0-1%) plus an inflation adjustment to principal every six months. For example, $1,000 in TIPS would be worth just a little over $1,030 if inflation were to average 3% for that year—assuming the locked in rate was 0%. The $1,030 figure would be higher if the locked in rate were above 1%. TIPS are best utilized in a sheltered account such as a retirement plan or variable annuity subaccount. Sheltering is the preferred choice because the crediting is taxable each year (i.e., in the example above, the $30 increase would be taxable).
The track record for TIPS is impressive, particularly when you consider this investment vehicle has virtually zero risk (due to its semi-annual inflation adjustment + backing by the U.S. government). TIPS have done substantially better than inflation over the past 11 years.