2023-10-25 05:48:57 ET
Summary
- Bond market performance has been negative for three consecutive years, with the iShares 20+ Year Treasury Bond ETF down over 50% from its peak.
- Falling bond prices are attributed to the Fed's anti-inflation campaign and the US government's large budget deficit, which increases supply and inflationary trends.
- Warren Buffett sees value in Treasuries and has invested $10 billion in US Treasuries, emphasizing the non-default thesis and the strength of the US economy.
The bond market is on track to close FY 2023 delivering an unprecedented underperformance, closing a negative nominal year-over-year mark-to-market loss for three consecutive years, with the iShares 20+ Year Treasury Bond ETF (TLT), currently down more than 50% from all time highs reached in mid-2020. Treasuries, and bond investors in general, are suffering like never before.
In that context, it is important to point out that bond prices have been falling due to a number of factors.
First, and perhaps most notably, bond prices are continuing to fall as a consequence to the FEDs “unfinished” anti-inflation campaign, which hiked short-dated yields by 525 basis points over the past 18 months, bringing the FED funds rate to 5.25-5.50%. In addition, while previously only short-dated yield’s ripped higher, this year also longer-dated yields started to move more aggressively on the “higher for longer” thesis.
The below chart reflects the thesis beautifully, reflecting how the FED members funds rate estimates for 2024 and 2025 over the summer months: While the median June projection for 2023 was somewhere around 4.88-5.12, the September projection sifted closer to the 5.13-5.67 range, implying there is still upside surprise potential to rates even as core CPI prints dropped to about 3% YoY.
A second argument about why bonds are trading lower relates to the enormous budget deficit of the U.S. government, which increases Treasuries supply against already stressed demand, while also provoking inflationary trends in the economy. In that context, bond vigilantes stand out likely as a key force in the bond market over the past few months. The concept of bond vigilantes is rooted in the idea that bond market participants, particularly those holding government bonds, speculate on the bond market impact of government policies. Specifically, if they believe that government actions, such as excessive deficit spending or overly loose monetary policy, could lead to inflation or default risk, they may respond by demanding higher yields on bonds – with strong respective believes also manifesting in the short-selling of bonds.
With that frame of reference, there are quite a few government actions that render bond investors concerned. Not only is the sharp budget deficit of the Biden administration likely contributing to a supply demand imbalance in the Treasuries market, but likely also inflation accreditive on lavish government spending. There are arguably no cases where such a combination is ideal, but the gravity of the situation is certainly compounded by both already high pile of U.S. government debt (more than 33 trillion, the last time I looked), as well as politicians’ willingness to leverage the threat of a debt default for negotiation power.
That said, bond vigilantes are very bearish: According to the latest COT report, the bond vigilantes (leveraged money, incl. hedge funds and alternative asset managers), have now accumulated a more than ~$500 billion net-short position on treasuries futures, with a breath-taking ~$270 billion short position on the 2-year futures alone.
Not all investors see the value proposition for Treasuries so bad, however. In fact, the Oracle of Omaha, Warren Buffett, is one of the investors that see value in government securities. In fact, he already liked Treasuries at approximately 4% yield for the 10 year. And when asked by CNBC how the Fitch downgrade changes his position towards Treasuries, Buffett said that
Berkshire bought $10 billion in U.S. Treasuries last Monday, and [we] bought $10 billion in Treasuries the previous Monday. The only question for next Monday is whether they will buy $10 billion in 3-month or 6-month [Treasuries].
Arguably, Buffett will now likely appreciate the value proposition for treasuries even more, as he frequently argued about the non-default thesis of the Dollar-backed treasury market, as well as the corporate strength of the United States. While bond vigilantes are concerned about the level of the U.S. debt, the sustainability of the budget deficit and the negotiation moves of political tactics, Buffett doesn’t think that these concerns are helpful when assessing the attractiveness of the U.S. debt as an investment vehicle, arguing :
There are some things people shouldn’t worry about ... This is one.
Personally, I tend to side with Buffett. Investors should consider that the U.S. is still home to the largest, best-moated and most profitable businesses in the world, and has the power to tax them with some discretionary decision power. Moreover, talking about debt sustainability, it should not be forgotten that most of the U.S. debt is written in nominal Dollar terms, implying that the actions of the Fed may support some debt monetization if things spiral out of control (not saying the Fed will monetize, just saying the Fed could ). And with the debt repayment question somewhat out of the question, the ~4% yield on the long-dated treasuries (20+ years) looks indeed attractive. In fact, treasuries look almost like a no-brainer.
If an investor believes that the Fed funds rate will be cut back towards 2% eventually, which is still considerably above the post-GFC period, then Treasuries should make for an excellent trade on that thesis. In fact, referencing an effective duration of 16 for TLT, it is suggested that for every 100 basis point drop in yields, long-dated Treasuries should appreciate ~16%. Ignoring convexity, a normalization of interest rates (200 basis points) would thus likely spark a 30-32% price appreciation.
Conclusion
In conclusion, the bond market's underperformance in FY 2023 has been nothing short of remarkable, with an unprecedented streak of negative nominal year-over-year mark-to-market losses for three consecutive years. One key factor contributing to the decline in bond prices is the Federal Reserve's ongoing battle against inflation, which has led to higher short-term yields. Recently, longer-dated yields have also started to rise, reflecting the "higher for longer" outlook. Another significant factor is the substantial budget deficit of the U.S. government, which has increased the supply of Treasuries while demand remains stressed.
While bond vigilantes worry about inflation, the U.S. debt level, and the government's budget deficit, not all investors see Treasuries in a negative light. Warren Buffett, for instance, sees value in government securities and has invested significantly in them. He believes in the strength of the U.S. and the non-default thesis of the Dollar-backed treasury market. On the intellectual argument whether bonds investments are attractive, I side my bets once again with the Oracle of Omaha, Buffett. Personally, I believe that the Fed funds rate will eventually be reduced to around 2%, which would render long-dated bonds an excellent trade, as a drop in yields would likely lead to significant price appreciation on the backdrop of a portfolio duration equal to 8-10 (assuming a portfolio holding 10 year Treasuries). And while investors wait for the Fed to cut rates, a dividend-stocks beating yield at low risk sweetens the waiting time.
For further details see:
Warren Buffett Vs. Bond Vigilantes: Disagreements On The Attractiveness Of U.S. Treasuries