AAII Investor Update: Not Enough Diversification from Long-Term Treasuries
Thursday, June 2, 2011
Charles Rotblut, CFA
AAII Journal Editor

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Ten-year Treasury notes may not be giving you enough comparative diversification benefits to justify their potential downside risk. Though long-term Treasuries have historically had low correlation coefficients with large-cap stocks, intermediate-term Treasuries are even less correlated with large-cap stocks.

I want to clearly state that is not an argument against holding Treasuries, even though yields on the benchmark 10-year note fell below 3% yesterday. Rather, it is about finding a proper balance between risk and reward.

Bonds are a form of a loan. The most common types of bonds pay a set percentage of interest over a specified period of time, referred to as the coupon rate. At maturity, the face, “par,” value of the bond is returned. Since the coupon rate does not change, bonds with longer maturities are more sensitive to interest rate changes than those with shorter maturities. All things being equal, an investor would rather not hold a bond with a low coupon rate when new bonds are being issued at higher coupon rates. This is why bond prices fall when interest rates rise, and why bond prices rise when interest rates fall.

You can see this relationship by watching changes in yield. Yield factors in both the interest rate paid by the bond and the actual price of the bond. It is a measure of the total cash flows you will receive by holding the bond to maturity.

In an environment where interest rates are projected to stay stable or fall over the next several years, long-term bonds have an appeal. An investor can lock in a comparatively good interest rate now. Unfortunately, given that yields on the 10-year Treasury note fell below 3% yesterday and the latest issuance of the benchmark note had a coupon that was not much higher, history suggests rates are likely to rise in the future. (The consensus view also calls for higher interest rates; when rates will actually rise and by how much are the big unknowns.)

In such an environment, the allocation benefit of long-term Treasuries may not be comparatively beneficial. According to the Ibbotson SBBI 2011 Yearbook, long-term Treasuries have a correlation coefficient of 0.11 to large-cap stocks. This means that long-term Treasuries have very different return characteristics than the S&P 500; not opposite, but different. (The closer a correlation coefficient gets to zero, the greater the diversification benefit. A correlation coefficient of +1.0 means returns should move in lockstep, whereas a correlation coefficient of -1.0 means returns are mirror opposites.)

Combining long-term Treasuries with large-cap stocks does provide diversification benefits. However, intermediate-term Treasuries have a correlation coefficient of 0.08. In other words, they are less correlated to large-cap stocks than long-term Treasuries are. This means you can get improved diversification with less interest rate risk. (In case you’re wondering, long-term corporate bonds have a correlation of 0.23 with large-cap stocks. The Ibbotson SBBI Yearbook uses a 20-year maturity for calculating long-term Treasury and corporate bond returns and a five-year maturity for intermediate-term Treasury returns.)

Diversification is just one consideration, however. Bonds do provide regular income and, depending on your needs, holding a longer-term bond may still make a lot of sense. You should consider the coupon rate paid by your bond, which may be higher than the yields currently quoted for Treasuries. Furthermore, bonds give you a return of investment, whereas stocks merely provide a return on investment. Finally, you can offset the interest rate risk by combining short-term bonds with your long-term bond holdings (a strategy referred to as a creating a “barbell”). If you own bond funds, you can either opt for funds with shorter durations or create a fund barbell by mixing long-term and short-term bond funds.

If you are interested in buying individual bonds, there is an ongoing conversation on the AAII.com discussion boards about how to buy them.

The Week Ahead

Just a handful of S&P 500 member companies will announce earnings results next week. Pall (PLL) will report on Wednesday. Brown-Forman (BF.B), J.M. Smucker (SJM) and National Semiconductor (NSM) are scheduled for Thursday.

The economic calendar is light as well. The Federal Reserve’s periodic Beige Book will be released on Wednesday. April international trade and April wholesale data will be published on Thursday. Friday will feature May import and export prices.

Federal Reserve Chairman Ben Bernanke and Dallas Federal Reserve President Richard Fisher will speak publicly on Monday. Philadelphia Federal Reserve Bank President Charles Plosser will speak on Monday and Thursday. Atlanta Federal Reserve Bank President Dennis Lockhart will speak on Tuesday. Kansas City Federal Reserve Bank President Tom Hoenig will speak on Wednesday. Federal Reserve Bank Vice Chair Janet Yellen will speak on Thursday.

The Treasury Department will auction $32 billion of three-year notes on Tuesday, $21 billion of 10-year notes on Wednesday and $13 billion of 30-year bonds on Thursday.

AAII Sentiment Survey

Sentiment Survey

This week’s AAII Sentiment Survey results:
  Bullish: 30.2%, up 4.6 points
  Neutral: 36.4%, up 3.4 points
  Bearish: 33.4%, down 8.0 points

Long-term averages:
  Bullish: 39%
  Neutral: 31%
  Bearish: 30%

Take the AAII Sentiment Survey »

Bullish sentiment, expectations that stock prices will rise over the next six months, rebounded in the latest AAII Sentiment Survey. Optimism increased 4.6 percentage points to 30.2%. Even with the increase, bullish sentiment remained below its historical average of 39% for the seventh consecutive week.

Neutral sentiment, expectations that stock prices will remain essentially flat over the next six months, rose 3.4 percentage points to 36.4%. This is only the third time since 2005 that neutral sentiment has been above 36%. The historical average is 31%.

Bearish sentiment, expectations that stock prices will fall over the next six months, dropped 8.0 percentage points to 33.4%. Though this is a four-week low, bearish sentiment remained above its historical average of 30% for the 14th time in 15 weeks.

The improvement in bullish sentiment followed atypically low readings during the past two weeks and occurred as stock prices largely rebounded during the survey period. (The survey runs from Thursday 12:01 a.m. to Wednesday 11:59 p.m.) Even with the changes, optimism remained below average while pessimism remained above average. The market’s volatility, the uneven pace of the economic recovery and inflationary pressures are all dampening individual investors’ spirits.

This week’s neutral sentiment reading is unusually high relative to what we’ve been seeing over the past several years and suggests an elevated level of uncertainty. Neutral sentiment, however, remains well within its historical norms. Higher readings were registered throughout the 1987—2005 period. The record high is 62.0%, which was recorded on June 3, 1988.

This week’s special question asked AAII members whether they thought 2011 and 2012 earnings estimates for the S&P 500 are realistic, too conservative or too optimistic. The majority of respondents thought the Thomson Reuters consensus forecasts for 16.9% profit growth this year and 13.4% growth next year were too high. Many said estimates were too optimistic, while others described them as being a bit high. Inflation and a lack of adequate job growth were common themes among skeptics. A minority of respondents described estimates as being realistic.

Here is a sampling of the responses:

  • “They are too optimistic, unless employment picks up.”
  • “I think they are too optimistic. When do analysts ever suggest that everything is not rosy?”
  • “Current and forecast profit levels cant keep growing without real, sustainable business and economic growth.”
  • “Too optimistic. Profits have already recovered from the Great Recession, and inflation constraints ought to hold back profits now.”
  • “Realistic for this year, but possibly too optimistic for the following year.”

Are you bullish, bearish or neutral? Take the AAII Sentiment Survey and tell us.