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Financial Industry Insights from Advisors Asset Management
On May 02, 2012
Safest Market in the World?
Over the years, investors have exercised a trading practice known as the “flight to quality.” This has meant that in times of uncertainty, investors sell risk assets and invest in riskless assets, which in many cases are U.S. Treasuries. For this comfort level, the investor currently receives around a 2% taxable yield on a 10-year Treasury. The important realization is that the “flight to quality” is about credit risk; not market risk. In our opinion, if you are in the camp that the economy is not doing well or that we are in for a double-dip recession then you might want to stick with these riskless assets; you might do relatively well. If you believe as I do that the economy is rebounding even at a slow pace and/or that all the stimulus that has been injected into the economy will eventually ignite inflation, then you may want to consider the following:
*The highest yield ever on the 10-year Treasury was a 15.84% at close of business (COB) 9/30/81.
*The lowest yield on the 10-year Treasury was a 1.71% at COB 9/22/11.
That makes an average between the high and low over this period of time an 8.767% yield.
However, just sticking to this century; the highest yield was a 6.78% on COB 1/20/00, which makes the simple average between the high and low a 4.24% yield.
I happen to think that a 4.24% yield on the 10-year Treasury is not unreasonable to expect some time in the future. This 4.24% yield on the 10-year Treasury bond is roughly 225 basis points (BPS) or 2.25% higher yield than the 1.98% which was the yield on COB on 4/18/12., All things being equal, same coupon rate, same maturity, etc., the higher the yield the lower the value of the bond. In this example a yield of a 1.98% (2% coupon) produces a value of $100.25. The yield of 4.24% produces a bond value of approximately $82. In this example, if rates rise 2.25%, the value of the bond drops 18%. For this risk, the investor receives an interest payment of 2.00% – taxable. Inflation is estimated around 2% for 2012, which theoretically means the investor is treading water with regards to purchasing power. There are other investments that have the potential to pay the investor more for the same market risk.
For the generation that experienced the higher interest rates mentioned above and believe that higher rates are not unusual, the 8.767% average between the all-time high and low rates on the 10-year Treasury produce a dollar price of $56.00, or a loss of 44%. We are not suggesting we will reach these types of interest rates; just noting that we have been there before. What we are suggesting is that there are other investments with a relatively higher credit risk that have the potential to pay you more for the same market risk.
On the other hand, it should be noted that even with a 10-year Treasury there is a definite maturity where the investor receives their full par amount back; this cannot be said for all fixed income investments such as fixed income funds, but that is a different discussion. Of course if you would like more information on this discussion you should read Bond Investors Beware: Quicksand Ahead.
This commentary is for informational purposes only. All investments are subject to risk and past performance is no guarantee of future results. Please see the disclosures webpage for additional risk information. For additional commentary or financial resources, please visit www.aamlive.com/blog.
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