Let’s start with the disclaimer. I’m not telling you what to buy. I’m not telling you what not to buy. I am merely sharing interesting ideas that you can decide whether they have merit or not for your situation.
Today, we will talk about the pros and cons of buying Treasury bonds at today’s yields. Before we do though, as the title suggests, we are going to discuss how to think about opportunity cost and why there is a good chance you’re doing it wrong.
But…before we do, we have a brief commercial pause to remind you to visit informedinsurance.com to find out if you are getting what you need from your homeowners insurance.
Also, for those not following twitter, I shared my take on the Lemonade-Chewy distribution deal there.
Rethinking Opportunity Cost
Many investment courses talk about opportunity cost. If you buy an individual stock, you might compare it to the opportunity cost of buying an index fund. Or if you buy an index fund, you might compare it to the return on a risk free bond.
The whole concept of the equity risk premium is to compensate you for the added volatility risk of not owning a government bond. In other words, the opportunity cost of owning safe bonds is the potential to earn the higher return provided by the equity risk premium.
This is all well and good and not inherently wrong. However, it isn’t the whole story either. Most people tend to look at opportunity cost one dimensionally.
For example, someone will decide between a 15 year and 30 year mortgage based on the difference in the interest rate or size of the monthly payment. Neither is really the proper way to look at it. You also need to consider what else you might do with your money.
So, if a 30 year mortgage lets you put the lower monthly payment into investments with high returns, it will more than make up for whatever extra interest you paid. That is usually something that requires risk, though not always.
To share some personal experience, I have always carried a 30 year mortgage for the max amount I could borrow because rates were historically low.
I figured there would come a day where I could earn more in Treasuries than what I paid in interest. While waiting for that time, I could own equities which had just come off a big bear market.
Guess what? Equities crushed the mortgage coupon over the next decade and now I am buying 3 month Treasures above my mortgage rate. I am very happy to have that rate locked in for nearly 30 more years (refinanced along the way to restart the 30 year clock).
That’s how you play multi dimensional opportunity cost. How does this apply to investing? It’s actually pretty similar.
Volatility Creates Opportunities
Bonds vs. stocks. That’s how most financial advisors have you think, right? What should my allocation to bonds vs. stocks be? That’s only a piece of the puzzle because it ignores the opportunities created by volatility.
For example, if I told you stocks would be down 10% for the next two years and you could make 4% in bonds, most people would buy bonds. My argument is that is wrong, or at least incomplete.
What if stocks dropped 20% tomorrow and then rose 12.5% from there for the next two years? Someone who got in today would lose 10%. Someone who got in after tomorrow would make 12.5%…which is better than making 4% in bonds.
When volatility is low, the odds of a new and better opportunity coming along are low. When volatility rises, the opportunity set changes more rapidly and there is the potential to enhance returns.
The problem is it’s not always easy to take advantage of these opportunities. Let’s run through some scenarios to see why.
Buy Two Year Treasuries?
One of the more common pieces of advice you’ll here these days is to buy two year Treasury bonds. After all, they yield 4.5%! This is fantastic. It has no risk!
Well, it’s true it has no risk in that you know you will earn exactly 4.5% and the government should be around to pay you in two years.
However, from an opportunity risk perspective, it has a lot of risk. The S&P is down over 20% for the year. Do you think it will be lower two years from now? If not, why avoid stocks just because they might go down in the near term?
But the bigger issue is, if you commit to two year Treasuries, you will miss out on the opportunity that the S&P does go down in the near term. Let’s say the S&P drops to 3000. Wouldn’t you want to buy it then?
And yet your money would be tied up in two year Treasuries. Yes, you could sell those later to buy beaten up stocks, but hard to say if you’ll sell at a gain or loss.
You need to consider before you allocate your $ to bonds, not just whether there will be a higher return opportunity today, but whether there will be one in the near future.
This is the point most people miss when they buy safe investments in a bear market. If your safe investment isn’t liquid, you’re opportunity cost is way higher than you realize.
Buy Six Month Treasuries?
Guess what? Six month Treasuries yield the same 4.5% as two year notes. So what are some reasons to buy the two year instead? Mainly if you think rates will go down over time and you won’t be able to reinvest six months from now at the same 4.5%.
Of course, rates could keep going up and by investing shorter you may be able to reinvest at perhaps 5%. But more importantly, there is a better chance we are still in a bear market six months from now than two years from now.
Thus, in six months you may still be able to buy stocks cheaply (and perhaps with more visibility that the economy has bottomed) while in two years it may be too late. So, by investing shorter, you create more optionality to find better future returns.
Yes, there is a chance rates go down to 3% in six months and equity prospects look worse, but that is a less likely outcome. More likely is you either reinvest for six more months in the 4s or even 5s or you switch to stocks.
Buy Three Month Treasuries?
There is yet another option. Buy three month Treasuries. These are around 4%. So you give up a little yield, but then again, the Fed is not done raising so three months out you will like get 4.5% or more.
Three month bills create the most opportunity benefit. You probably can reinvest at the same or higher rates or you can see if in three months the market is way down and switch some to stocks.
Thus, if you think market volatility will remain high, it may be worth giving up 50bp of yield to have the ability to take advantage of market selloffs.
Yes, it is possible that equities go up right away and you never get to switch and that somewhere over the next two years interest rates come down and you earn less than 4.5% rolling your bills for two years.
But the cost of this is pretty low compared to the options you create by retaining flexibility. In fact, you can actually think of these tradeoffs as premiums you pay to buy and sell options.
Buying and Selling Puts
In other words, deploying cash is like selling a put option. You are saying that the market won’t go down and provide a better future opportunity, so you won’t have lost anything from writing the put.
If you know anything about option pricing, you know that higher volatility raises the price of options. This is because large price moves are more likely and thus there is a greater probability the option pays out.
Thus, if you are going to write that put, you better receive a higher price for it. The good news is the price (in this case, the interest rate) is a lot higher than a year ago. In normal markets, it may be worth writing the put for a 4.5% return.
The problem is volatility is high enough that there is a higher than average probability you’ll get to buy stocks at depressed levels and you would have been better off earning 0% on cash for a number of months to later earn 25+% on stocks rather than clipping your 4.5%.
If deploying cash is selling a put, then that means holding cash is buying a put. If you hold cash, you earn close to 0% (though not always). Since you could have earned 4+% in a Treasury, you paid ~4% for your put protection.
Is this worth it? If the market goes down enough where you think stocks are long term attractive, then yes, since you will be able to monetize your put.
To be clear, there is no right answer. This all depends on your personal risk tolerance. But the point is sitting and doing nothing but waiting for better options should be in your decision tree.
Most people feel compelled to do something and can’t take advantage of the best opportunities when they come around.
Exploring An Optimal Strategy
So what might you want to do? I’m not going to tell you that, but I can share a final thought of one idea I’ve considered.
I implied this a bit earlier, but you can make a case that if the market truly gets clobbered, you’ll have what’s called positive convexity owning short Treasuries. That’s another way of saying you win either way.
How? If the market went down 20+% because of a crisis, say a currency collapses or a bank fails, there would likely be a flight to safety. This means people would buy Treasuries and the price would rise.
Thus, you may be able to sell your Treasuries at a gain and use the proceeds to buy stocks at the bottom.
Conversely, if higher inflation causes the market to crash, you will be happy holding your Treasuries a little longer and you can reinvest them at even higher yields at maturity or buy stocks at that time.
Of course, these aren’t the only two scenarios and you could end up deciding whether to sell Treasuries at a loss to buy beaten up stocks. Or the market could start a huge rally and you miss it while tied up in bonds.
If you want to reduce those risks, you’re better off in shorter Treasuries, so a year or less. Interestingly, there is practically no difference between 6 and 12 month yields, so that might push you in one direction over the other.
The main scenario that favors 2 or even 3 year Treasuries is if you think inflation has peaked and will come down a lot but the market won’t rally because we’re in a recession.
In that case, bond yields will decline and you’ll have locked in top of the market yields without missing an equity rally. This is certainly a viable scenario, but it is a bit of trying to thread the needle.
One last thing. This thought process isn’t only for investing. It can apply to any capital deployment like insurance capacity. Should we write the business at today’s prices or hold back in case they get better?
IRR analyses on capital projects should consider opportunity cost and volatility more explicitly (they sort of do through the discount rate but that’s only a proxy) by incorporating elements of option pricing.
Even sports teams could apply this framework to spending against a salary cap…what better opportunity might come along later to add a star player?
There are lots of ways to apply this lesson (if I’m dating someone I’m not going to marry, am I missing out on looking for a better match?) and we all do them to various degrees in certain situations, but my message today is to think about opportunity cost more explicitly when you make decisions and you will arrive at better outcomes.