Disclosure! Disclosure! Disclosure! This is not investment advice. I am only describing what I am doing. You should do whatever you think is best for you.
So let me head off something right off the jump. I am not suggesting Treasuries will beat stocks over the next three years.
I think they may, but they don’t have to for me to be happy with this trade. So if you want to argue about whether stocks will outperform bonds you’re in the wrong place.
My argument for owning Treasuries today is they give you the best chance to maximize your cumulative returns.
What do I mean by that? You can potentially earn better than both the Treasury and S&P returns. This can happen if bond prices rise at the same time as stocks fall. You would then sell your bonds to buy cheaper stocks.
Background
Let me run some quick numbers first before diving into the analysis. Three year Treasuries are yielding nearly 5% currently. That means, compounded, a $100 purchase today will pay you just over $115 in three years.
Why not buy a one year Treasury since it pays 5.5%? Because if a year from now the Fed cuts rate to 3%, you will be reinvesting lower and only have $112 after three years.
To break even reinvesting one year at a time, you have to assume either the Fed cuts to 4.5% in a year and stays there for two years or, perhaps, they don’t cut for two years and then drop to 3.5% in year three.
My bet is the Fed will cut either further or sooner than that.
So, if you were to hold the bond for the full three years, where do you break even vs. stocks?
At around a 4800 future S&P. The dividend yield will produce ~5% over three years, so you need the index to rise by 10% to return the same 15% as the bond.
But you don’t have to hold your Treasuries for the full three years. You can sell them at any time.
What would make you do that? For one, they could rise in price. A three year Treasury has a duration of 3 which means every 1% move in yields will change the price by 3%.
In other words, if the 3 year fell to 3.8%, you could sell your bond for a 3% gain.
The other reason you might sell is if the stock market dropped a bunch and you wanted to sell bonds to buy stocks.
As you’ll see, a big part of my analysis is handicapping the odds of this happening.
Scenario Analysis
I’m going to lay out different potential outcomes and how I think bonds and stocks would respond to each.
Soft Landing
In this scenario, inflation moderates toward 2% without leading to a recession. Falling inflation would drive interest rates lower which would mean it’s a good thing I locked in higher yields for the next three years.
Treasury bills would likely fall to 2-3% and the three year yield might decline to 3-3.5%. The stock market would do well given the end of inflation and no recession, but I could always sell my bonds at a gain to chase the rising market.
Limbo
In this case, we get continued mixed signals on the economy and inflation. The Fed keeps rates neutral as a result.
Asset prices likely go sideways, so I can hold my bonds until maturity without missing out on anything.
Inflation Accelerates
The Fed is still behind the curve and needs to raise rates to 7%. Rates would be higher across the yield curve and I would lose on my bond bet.
While I can hold to maturity, I will miss out on the opportunity to invest short at 7%.
However, the stock market gets crushed in this scenario. I would gladly sell my Treasuries at a 3-5% loss to buy stocks down 15-20%.
Recession
What if the higher rates finally pinch the economy and lead to recession? This would lead the Fed to cut to 2% or even lower.
The three year is probably at 2.5%. That’s a nice 7% gain. But what else?
The market is in the tank. It is no longer pricing in a recession so it could decline 20%. This means I make 7% on my bond and can take profits to buy stocks at their lows.
Worst Case
So it seems like I am neutral or positive in every scenario. Can that be so? Probably not.
The one case where I lose is if we continue on the path of the last month where rates go higher, so bonds decline in price, but stocks also fall because higher rates mean lower valuations.
While this can continue in the short term, I don’t see a good argument for how it continues for three years.
So, yes, in most reasonable scenarios, I either hold my bonds happily to maturity or sell them to buy stocks when they are cheaper.
If that sounds too good to be true, it’s about to get better…
The Price of Uncertainty
One thing is certain. All the scenarios I described above will feature plenty of uncertainty and volatility along the way.
As the market tries to figure out which is most likely, prices will gyrate. This means I only need one point in time where yields fall at the same time as stocks to cash out.
Even if the market is at 5000 in three years, if it hits 4000 somewhere along the way, then I win. I can sell the bonds at a gain to buy cheaper stocks.
What are the odds we don’t have any material selloff for the next three years? Probably pretty low.
And if it doesn’t happen, I’m giving up an expected return of ~3%/yr (arguably lower since stocks are above long term valuations and recession risk is above normal).
Is 3% a fair price to pay if I’m wrong?
The Cheapest Put Option Option
We can look at option pricing for reference. 12 month at the money puts on the S&P (so you win if the market finishes lower than today’s close) cost >5%.
You could buy the S&P and, simultaneously, pay 5% for an at the money put. If the market is up, you earn the S&P -5%. If it is down, you only lose the 5%.
Compare this to the Treasury strategy. If the market is up 5%, you are even. If it rises 10%, you lose by 5%, and so on.
So to trail the S&P by >5%, the market has to be up double digit. If it is up 0-10%, you do better than buying the puts.
If the market is down, instead of losing 5%, you have made 5%…and probably more because your bond price will likely rise.
So, in any scenario but a double digit up market, owning a 3 year Treasury provides better returns than buying an at the money put (and for those who want to go deeper, you can buy a 10% OTM call to hedge that and the net returns are still better).
This is all a fancy way of saying owning Treasuries is the best way to hedge market risk.
Cumulative Returns
Back to those cumulative returns I mentioned up top, let’s do a hypothetical. Assume the S&P in three years is at 5500 (10% annual return including dividends).
But assume along the way the market falls to 4000 and the three year yield falls to 3.5%. I sell the bonds at a 4% gain and switch to stocks. The gain from 4000 to 5500 is >40% (including dividends).
Note, if I bought $100 of bonds and sell them at $104, I get to buy $104 of stock. That leads to $143 of stock value in three years. Add in the dividends along the way and you’re at nearly $150.
If I just owned the stock the whole way, I’d have ~$133. That’s the difference between a 10% annual return and 14%. Investors pay a lot of money to outperform by 4%/yr!
I just outlined a simple strategy with a reasonable chance to outperform by 4% – and if I don’t get the opportunity to buy stocks for less, I’m happy owning 5% risk free returns.
Other Thoughts
Why three year and not two or five year? I’ve actually been buying those too. It’s really about how long you want to lock in today’s rates for and how much price risk you want to take.
Three years feels like the sweet spot for me, but, as noted, I have started doing some five years as well. Those will likely be the first I sell if the market sells off (since they will have larger price gains).
What’s the best way to buy Treasuries? You can do it at the government auctions at Treasury Direct. The downside of this is you have to wait for an auction and it’s a little more work to sell them.
I buy through Fidelity. They also give you access to off the run Treasuries (meaning ones from prior auctions) which tend to yield a little more.
I wrote a guide on how to do so here. They also make it very easy to sell and the spreads are reasonable. I suspect Vanguard and Schwab would have similar tools.
Final reminder, just because I am doing this, doesn’t mean you should.
I don’t need to access the principal if rates don’t fall, and I am happy with a 5% nominal return on this allocation. I also have more skill than the average person to know when to sell and switch to stocks.
I wrote this to share my thinking in case some of you have been considering doing this on your own, but you need to decide what is best for your situation.