Treasury Bonds - The Next "Lost Decade?"

FORECASTS & TRENDS E-LETTER
by Gary D. Halbert
August 3, 2010

IN THIS ISSUE:

1. The Erratic Course of Treasury Bonds

2. The Next “Lost Decade?”

3. How to Capitalize on Rising and Falling Yields

4. Attend Our Free Long-Term T-Bond Webinar

Introduction

Should you invest in long-term US Treasury bonds now? It’s a good question since many investors are flocking into these and other bonds in a big way, and have been ever since the financial crisis in 2008. According to data from the Investment Company Institute, mutual fund investors have continued to pour tens of billions of dollars per month into taxable bond funds, much of it in Treasury bond funds. With interest rates at or near all-time lows, it would seem that bond prices would have to fall in the future, making long-term Treasury bonds a very risky bet right now.

However, long-term Treasury bonds have a tendency to confound even the most knowledgeable experts. A little over a year ago, I wrote about how long-term Treasury bonds had outperformed stocks over the last 30 to 40 years, a fact that surprises many investors. In that E-Letter, I cited studies that turned Wall Street’s conventional wisdom on its ear by showing how Treasury bonds, the safest investment around when held to maturity, had actually outperformed stocks over an extended period of time.

The experts tell us that Treasury bonds aren’t supposed to outperform stocks over long periods of time but, for the most part, they have. Perhaps the status of US Treasury securities as one of the safest (if not THE safest) investments, especially during times of global turmoil, explains why Treasury bonds have been so popular in recent years, thus confounding the “experts.”

In this week’s E-Letter, I’m going to discuss the outlook for Treasury bonds for both the short-term and long-term future. We’ll cover the impact of geopolitical influences, a struggling economic recovery, and the possible effects of continued deficit spending by the US government. We might find that we’d consider ourselves lucky if bonds struggle for only a decade and not much longer.

Finally, I’ll guide you to a way to invest in long-term Treasury bonds that has the potential for gains no matter which way bond yields go in the future. In fact, we’re having an online seminar featuring this innovative investment program this coming Thursday, August 5th at 1:00 PM Eastern Time (10:00 AM Pacific). Someone is going to have the potential to make a lot of money when interest rates turn higher, and it might as well be you. Click on the link below to register for this free, no-obligation learning experience:

https://www1.gotomeeting.com/register/460995961

The Erratic Course of Treasury Bonds

Looking back over the last few years, long-term Treasury bonds have had quite a ride as measured by the Barclays Capital Long-Term Treasury Bond Index. After posting a gain of over 9% in 2007, just as the subprime crisis was beginning to unfold, long-term Treasuries returned over 24% in 2008 as the credit markets seized up. In 2008, the long-term Treasury bond asset class was virtually the only one to post a gain that year as investors sold everything and sought the safety that only US Treasuries can provide.

In 2009, long-term Treasury bonds pulled back, losing almost 13% as investors realized that the global economy wasn’t going to melt down and they gradually regained an appetite for risk assets such as stocks and stock mutual funds. Early in 2010, the experts decided that the good times in bonds were over. In a Bloomberg Radio interview in March, bond guru Bill Gross stated that Treasury bonds had “…seen their best days.”

Yet, long-term Treasury bonds had the highest return of any asset class during the first half of 2010, despite experts’ predictions to the contrary. Many cite the sovereign debt crisis experienced by the “PIIGS” (Portugal, Italy, Ireland, Greece and Spain) as the source of global uncertainty that prompted another “flight to quality.” And looking forward, we see no shortage of potential crises that might prompt yet another shift to Treasury bonds, driving yields down and prices up.

A recent Financial Times article noted that Royal Bank of Scotland analysts had announced a significant downward revision to their US Treasury bond yield forecast, predicting that the yield on 10-year Treasury notes could fall as low as 2.75% during the 4Q of 2010, down from a prediction of 4.4% at the beginning of the year. If accurate, this could mean further downward pressure on bond yields, moving prices upwards.

Since long-term Treasury bonds are also sensitive to inflation expectations, the rate of economic recovery could also affect bond prices in the short-term. Last week’s announcement of only 2.4% GDP growth in the 2Q could actually help to feed an expectation of disinflation (or even full-blown deflation), which could also be good for long-term Treasury bond prices in the short term.

While the above factors may create upward trends in bond prices in the short term, it’s the long-term view that we need to be concerned about. Today’s historically low interest rates have to go up at some point, for a host of reasons. What will happen if foreign buyers of our Treasury debt suddenly demand higher interest? What if one or more of the major ratings firms lowers the US Treasury bond rating? What if inflation rears its ugly head due to out of control spending and trillion-dollar deficits?

Millions of investors who have herded into bonds over the last two years will get hammered when interest rates begin to trend higher, and they will at some point.

A “Lost Decade” in Bonds?

You may recall many articles, including in this E-Letter, about the “lost decade” in stocks. This term refers to a 10-year period during 2000-2009 in which stocks had a negative return. While most of the articles came out at the end of the first full decade of the new millennium, a review of recent data indicates that the phenomenon in stocks is still going on. As of the end of June 2010, the rolling 10-year annualized return for the S&P 500 Index is a loss of 1.59%.

In light of historically low interest rates, some analysts are now predicting that bonds, and especially long-term Treasury bonds, may be in for a lost decade of their own. After a significant multi-decade run of favorable returns, I guess it’s not unreasonable to assume that the situation could reverse.

Don’t get me wrong, I’m not trying to talk down US Treasury bonds. It’s just that much of the attractiveness of these bonds to global investors has been that the US is less troubled than some of the other developed economies across the globe. Being the least bad in a gathering of global economies may make you the best choice as a safe harbor, but it doesn’t mean that your economy is suddenly healthy.

With interest rates at or near historic lows, there seems to be nowhere for them to go but up. Sure, we might see some periodic spikes in bond prices due to global uncertainty, but it’s important to remember that interest rates are the true determinant of bond prices. When interest rates eventually begin to rise, and they will, the situation in bonds won’t be pretty.

If we are, indeed, in store for a lost decade in bonds, then the money flowing into bond mutual funds from retail investors may be setting these people up for another big disappointment. In the good old days, we used to think of bonds as less risky and volatile than stocks. However, in an environment of rising interest rates and possible inflation, long-term Treasury bonds could be just as risky as stocks, if not more so.

Unfortunately, many of these retail investors are looking in the rear-view mirror when making their investment decisions. The last 10 years have been good for bonds, while stocks have continued to suffer. Using this backwards-looking approach, investors are obviously choosing the asset class that did best over the last decade without thinking about what might happen in the years to come.

How to Capitalize on Rising and Falling Yields

I think it’s pretty clear from the above discussion that the “experts” have no idea which way bonds will move in the near term. While continued out-of-control deficit spending will almost certainly create upward pressure on yields eventually, no one knows exactly when this might happen. I don’t have a crystal ball to tell you how long-term Treasury bonds will continue to perform well, but I can tell you about an investment strategy that has the potential to make money no matter which way Treasury bond yields go in the future.

Since our AdvisorLink® Program began in 1995, we had searched for a strategy that actively manages US Treasury bonds, and especially those with long-term maturities. However, it wasn’t until 2007 that we met the principals of Hg Capital Advisors and were introduced to their Long/Short Government Bond (“LSGB”) strategy. Byron Haven, Ted Lundgren and Dennis Shaw teamed up to create this active management strategy that seeks to capitalize on both rising and falling yield trends.

Since we have previously introduced the Hg Capital Long/Short Government Bond (LSGB) program in the past, I’m not going to repeat much of the background information. However, in light of the various forces affecting trends in long-term Treasury bond yields right now, I think that our more aggressive readers may want to consider allocating a portion of their risk capital to this program now. One big reason is performance.

Hg Capital’s LSGB program has delivered an average annualized return of over 16% this year as of June 30. The LSGB program also posted a whopping gain of 60.4% in 2009 as interest rates went back up temporarily. These are actual returns in real accounts, including my own account, net of all fees and expenses. As always, past performance is no guarantee of future success.

Compare Hg’s returns to the Barclays LT Treasury Index that posted a 12.93% loss in 2009, which illustrates the value of having a strategy that can “short” the Treasury bond market. Of course, Hg Capital’s LSGB program is not without risk, having posted a worst drawdown of -25% during the worst of the credit crisis in 2008.

I’ll discuss performance in more detail below, but let’s first talk about Hg’s proprietary strategy.

The Long/Short Government Bond Trading Model

Hg Capital’s bond trading model is a 100% mechanical, quantitative approach based on actual observations of market activity. From these observations, Hg’s portfolio managers have identified a number of what they call “rules” and have incorporated them into the LSGB strategy. It is important to note that these rules are actual observations of historical market activity, as opposed to conceptual ideas of how it “might work” or “should have worked.” Hg also stresses that their rules are not developed by optimizing or “curve fitting” to historical data, since optimized models often fail to produce favorable ongoing results.

Each day, Hg Capital enters current market data into their computer system, and their software analyzes the various bond yield rules in order to determine which single rule is the most likely, from a statistical standpoint, to be indicative of the market’s action during the next trading day. As you might imagine, the computing power necessary to run this analysis is extensive.

The trading model can produce one of three alternative signals: 1) invest on the long side of the long-term Treasury market; 2) short the Treasury market using a specialized “inverse” mutual fund; or 3) go to a cash position (money market fund). All positions use 100% of the account and there are never any partial or staged positions. The LSGB Program uses specialized mutual funds sponsored by the Rydex family of mutual funds that provide a long and short exposure to Treasury bond price fluctuations. The long side also has a moderate 1.2X leverage, but there is no leverage available in the short (inverse) fund.

The primary emphasis of the LSGB model is to identify the position with the highest probability of gain during the next day’s market action. If there is no clear trend, the strategy remains in the Rydex US Government Money Market Fund. The strategy does not attempt to predict what the market may do over the next week, month or year. All it is concerned with is the next day’s market action. If the model is long 20 days in a row, this means that it got 20 independent signals on 20 consecutive trading days that all said the program should be long.

The Hg trading model is 100% mechanical, and Hg will not override a signal, even in the case of a national emergency. Hg has, however, modified the model as necessary to adapt to changing market conditions. For example, when we first offered the LSGB program, it did not have a way to go to cash and was always either long or short. In 2008, this proved to be problematic, so Hg’s principals went to work and developed a way for the strategy to be neutral using a money market fund.

Hg’s own statistical analysis indicates that their systems have been right approximately 60% of the time, based on daily historical data. Our month-end performance analysis shows the bond program has had a positive monthly return approximately 67% of the time, but remember that past performance can’t guarantee future results.

Hg’s methodology does not employ any formal stop-loss techniques. However, since no signal lasts for more than one trading day, the effect of a bad trade may be limited by its short duration. Hg is quick to point out that the Long/Short Government Bond Program is aggressive, and should not be seen as an option for investors who want are looking for a traditional buy-and-hold Treasury bond exposure.

Performance Evaluation

The detailed performance information linked below shows that the LSGB Program compares very well to equity and bond benchmarks, both on an inception-to-date and year-to-date basis. The LSGB Program is also virtually non-correlated to the broad stock and bond markets, as well as to the other investment programs offered by Halbert Wealth Management, as I will discuss in more detail later on.

Since its inception in December of 2004, the Hg Capital Advisors Long/Short Government Bond Program has posted an annualized return of 16.77% as of the end of June, net of all fees and expenses. The worst-ever drawdown (peak to valley losing period) was –25.01%, which occurred during the recent subprime meltdown at a time when the model did not allow for a move to a neutral position in the money market.

Click on the link below to see the actual performance history and analytical data for more comparisons along with detailed monthly returns. Past performance does not guarantee future success. Also be sure to read additional important disclosures at the end of this E-Letter.

Hg Capital Long/Short Government Bond Performance Data

Correlation is the Key

As I have previously noted, the Hg Capital LSGB Program seeks capital gains from frequent trading of long bond index mutual funds based on the movement of interest rates. With that being the case, you may be wondering why you should consider this program, since it is so much like actively managed equity investments. After all, if the Advisor is managing the asset for capital gains, what does it matter whether it’s a stock or bond?

That’s a very good question. The answer is that the potential for capital gains in bonds, both long and short, generally occur independently from those of equity investments. As a result, successful trading activities can produce a return that has little or no correlation with both equity and bond indexes. By correlation, I mean the tendency of an investment to go up or down in relation to other investments.

Non-correlated investments are often preferred because they have the potential for gain without respect to how any other investment in the portfolio may perform.

The chart below will illustrate this concept. It shows the extent to which Hg Capital’s LSGB Program’s performance is correlated to major stock and Treasury bond market indexes. A value of 0.700 to 1.000 is indicative of a high correlation, values between 0.400 and 0.700 indicate a moderate correlation, and values below 0.400 indicate little or no correlation.

Market Index:	Hg LSGB Program R-Squared Correlation
S&P 500 Index	0.04
Barclays Long-Term Treasury Index	0.04

The above R-Squared correlation analysis covers a period of time from the inception of the Hg LSGB Program in December 2004 through June 30, 2010. Past R-Squared Correlation of the Hg LSGB Program to these indexes is not necessarily indicative of future correlation, and there is no guarantee that these numbers will not change significantly over time. Be sure to read the Important Notes at the end of this E-Letter.

As you see from the chart, the LSGB Program has had virtually no correlation with the major stock market index in the past. It even goes one better by not having a high historical correlation to the Barclays Long-Term Treasury Bond Index, which is what a buy-and-hold position in the Treasury bonds would have produced.

What does this mean to you? It means that you can add an uncorrelated asset to your portfolio for additional diversification and potential for gains. If the LSGB Program continues to identify trends in bonds as it has in the past, it could provide a degree of risk management to virtually any portfolio.

Other ways to use the Long/Short Government Bond Program include:

As a long-term bond allocation for aggressive investors.
As a non-correlated hedge for your bond or equity allocations.
As a long/short strategy within an alternative investment allocation.
As a replacement for aggressive long-only equity strategies in uncertain or declining markets.

Conclusions

Investors have been herding into US Treasury bonds ever since the financial crisis in 2008. Treasury bond yields are now the lowest in the last 50 years. Meanwhile the government is racking up trillion-dollar deficits. At some point, T-bond yields are going to turn higher, perhaps significantly higher. When that happens, millions of bond investors are going to get hurt.

When interest rates do turn higher, the only people that will make money in Treasury bonds are those who are SHORT. Hg Capital has the potential to do just that, plus it also seeks to make money on the long side should we experience any additional “flights to quality.” Now may be an excellent time to consider Hg's LSGB program as part of your portfolio. As I said earlier, someone is going to have the potential to make a lot of money when interest rates turn higher, and it might as well be you.

I think Hg Capital’s Long/Short Government Bond Program may be an excellent way to include an actively managed Treasury bond exposure in a diversified portfolio. It offers the potential to make money in both rising and falling interest rate environments, by trading long and short, which is attractive to many investors.

However, it should not be viewed as a conservative bond investment. Many investors include Treasury bonds in their portfolios for the safety and security of the asset class. While that’s generally true if you buy and hold individual bonds to maturity, it is important to note that this is not the case when bonds (or bond mutual funds) are frequently traded, and especially not when long and short positions are taken.

Another aggressive factor of the LSGB Program is that it employs 1.2X leverage on the long side. Thus, you should consider the LSGB Program only if you can tolerate a significant amount of performance volatility as well as the potential for double-digit drawdowns from time to time.

I encourage you to check out Hg Capital Advisor’s Long/Short Government Bond Program and see how it fits with your other investments. As I noted above, we’re going to be presenting an online seminar (webinar) this coming Thursday, August 12 at 1:00 PM Eastern Time (10:00 AM Pacific) featuring Hg Capital. In this presentation, you’ll be able to hear directly from Byron Haven and Ted Lundgren about how the LSGB trading model works.

You’ll also have the opportunity to ask them questions about their strategy to better evaluate it for your own portfolio. Just click on the link below to register for this upcoming event, I think you’ll be glad you did:

https://www1.gotomeeting.com/register/460995961

(Note: A recording of the webinar will be available on the Halbert Wealth Management website shortly after the event for those who can’t sit in on the live presentation.)

If you would like to request materials or discuss the features of the LSGB Program prior to Thursday’s webinar, feel free to call one of our Investment Consultants at 800-348-3601 or e-mail us at info@halbertwealth.com and we’ll be happy to help you. You can also obtain additional information and contact us via our website at www.halbertwealth.com.

Hoping to avoid another lost decade,

Gary D. Halbert

IMPORTANT NOTES: Halbert Wealth Management, Inc. (HWM), Hg Capital Advisors, LLC, and Purcell Advisory Services, LLC (PAS) are Investment Advisors registered with the SEC and/or their respective states. Any opinions stated are intended as general observations, not specific or personal investment advice. Please consult a competent professional and the appropriate disclosure documents before making any investment decisions. Investments mentioned involve risk, and not all investments mentioned herein are appropriate for all investors. HWM receives compensation from PAS in exchange for introducing client accounts to the Advisors. For more information on HWM or PAS, please consult Form ADV Part II, available at no charge upon request. Officers, employees, and affiliates of HWM may have investments managed by the Advisors discussed herein or others.

As benchmarks for comparison, the Standard & Poor’s 500 Stock Index (which includes dividends) and the Barclays Long U.S. Treasury Index represent an unmanaged, passive buy-and-hold approach. The volatility and investment characteristics of these benchmarks cited may differ materially (more or less) from that of the Hg Capital Long/Short Government Bond trading program since they are unmanaged Indexes which cannot be invested in directly. The performance of the S & P 500 Stock Index and the Barclays Long U.S. Treasury Index is not meant to imply that investors should consider an investment in the Hg Capital Long/Short Government Bond trading program, which is actively managed, as comparable to an investment in the “blue chip” stocks that comprise the S & P 500 Stock Index or the US Treasury securities with a remaining maturity of 10 plus years that comprise the Barclays Long U.S. Treasury Index.

Historical performance data from 2007 to present represents the composite returns of representative accounts managed by Purcell, called the Purcell Dynamic US Government Bond. It reflects the reinvestment of dividends and other earnings, and is net of all transaction, custodial and Purcell’s maximum management fee of 2.50%. Performance prior to 2007 represents an actual account in a program named Hg Capital 199Hg-TYX, custodied at Rydex Series Trust, and verified by Theta Investment Research, LLC. These results reflect actual trades in a proprietary account of the Advisor, managed to mimic the Advisor’s trading signals. The results may not reflect the performance of actual client accounts due to contributions and withdrawals from client accounts, tax loss sales, client-imposed investment restrictions and other factors. These performance numbers have not been verified by HWM, and therefore HWM is not responsible for their accuracy. Since all accounts in the program are managed similarly, the results shown are representative of the majority of participants in the Program. The Program’s objective is to capitalize on the up and down movements in the price of the 30-year Treasury bond. Purcell Advisory Services utilizes research signals purchased from Hg Capital Advisors, an unaffiliated investment advisor. The signals are generated by the use of proprietary software developed by Hg Capital Advisors. Statistics for “Worst Drawdown” are calculated as of month-end. Drawdowns within a month may have been greater. PAST RESULTS ARE NOT NECESSARILY INDICATIVE OF FUTURE RESULTS. Mutual funds carry their own expenses which are outlined in the fund’s prospectus. An account with any Advisor is not a bank account and is not guaranteed by FDIC or any other governmental agency.

When reviewing past performance records, it is important to note that different accounts, even though they are traded pursuant to the same strategy, can have varying results. The reasons for this include: i) the period of time in which the accounts are active; ii) the timing of contributions and withdrawals; iii) the account size; iv) the minimum investment requirements and/or withdrawal restrictions; and v) the rate of brokerage commissions and transaction fees charged to an account. There can be no assurance that an account opened by any person will achieve performance returns similar to those provided herein for accounts traded pursuant to the Hg Capital LSGB trading program.

In addition, you should be aware that (i) the Hg Capital LSGB trading program is speculative and involves a high degree of risk; (ii) the Hg Capital LSGB trading program’s performance may be volatile; (iii) an investor could lose all or a substantial amount of his or her investment in the program; (iv) Purcell Advisory Services will have trading authority over an investor’s account and the use of a single advisor could mean lack of diversification and consequently higher risk; and (v) Hg Capital LSGB trading program’s fees and expenses (if any) will reduce an investor’s trading profits, or increase any trading losses.

Returns illustrated are net of the maximum management fees, custodial fees, underlying mutual fund management fees, and other fund expenses such as 12b-1 fees. Management fees are deducted from the account on a quarterly basis, and are not accrued monthly. They do not include the effect of annual IRA fees or mutual fund sales charges, if applicable. Dividends and capital gains have been reinvested. No adjustment has been made for income tax liability. Consult your tax advisor. “Annualized” returns take into account compounding of earnings over the course of an investment’s track record. Money market funds are not bank accounts, do not carry deposit insurance, and do involve risk of loss. The results shown are for a limited time period and may not be representative of the results that would be achieved over a full market cycle or in different economic and market environments.