Wednesday, October 13, 2010

The Trend Is Your Friend Till It Ends: Application to the Long Treasury Bond

The nearby chart shows the yield on the long (30 year duration) U. S. Treasury bond since it was instituted in the late 1970s. I have visually estimated the rate of decline of the yield since the early 1980s. At the least there has been a 3% decline per year.
(Taking a 13% yield in 1982 as the starting point from which to estimate a trend line provides a decline in yields of over 4% per year, so the numbers provided below are conservative.)
To clarify my terms, a 3% decline from a 10% yield would be a decline to 9.7%. A 3% decline from a 4% yield would be to 3.88%. In other words, I am estimating that from year to the next, the yield on the long bond drops to 97% of the prior year's yield.
Currently the yield is 3.82%.
The current bond rally began in 1981. Bond historians say that 36 years is the longest duration of a bond rally in U. S. history. Given record high yields in 1981 and record low short-term yields today, I am projecting for discussion purposes that the drop in rates continues for 5 more years at a straight 3% drop in rates yearly.
If this occurs and the yield curve remains moderately upsloping, the buyer of a 30-year bond tomorrow will in 5 years own a 25 year bond which may itself then yield 3.0%.
If that occurs, the annualized return to the purchaser of a zero-coupon 30-year T-bond would be 8.2%.
This discussion is of course theoretical. It ignores transaction costs, taxes and the like.
But it does show that the most liquid, non-callable way to bet on a decline in long-term interest rates while locking in a positive nominal return on capital can easily give stock-like returns.
All the same considerations apply to standard "par" bonds that pay interest, just "less so".
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