Yes, I Still Like Treasuries, and Here's Why

08/11/2010 1:00 pm EST

Focus: BONDS

Gary Shilling

Columnist, Forbes

Gary Shilling, editor of INSIGHT, recommended buying Treasuries again early this year, and he tells why he thinks they still have room to advance.

Treasury bonds performed magnificently in the first half. That was especially true in the second quarter, when they, along with the dollar, became the safe haven.

Treasury bonds of 30-year maturity, our favorite investment since 1981, when their yields peaked at 14.7%, returned 13.4% in appreciation in the first half, plus 2.3% in coupon yield, for a total return of 15.7%.

If you really believe, as we do, that interest rates are going down, you want to own the longest-maturity bond possible. It may surprise you that there’s more than 30% left in this “bond rally of a lifetime,” as we dubbed it in 1981.

A fall from 4% to 3% gives a 19.6% gain [on ordinary Treasuries]. Zero-coupon bonds deliver much more bang per buck. On a 30-year zero-coupon bond, a decline in rates from 4% to 3% leads to 34% appreciation.

I’ve liked Treasury bonds for the same reason investors like stocks—appreciation. Who would own the Standard & Poor’s 500 index solely for its current miserly dividend yield of 1.9%?

I’ve also always liked Treasury coupon and zero-coupon bonds because of their three sterling qualities. First, they have gigantic liquidity, with huge trading volume each day.

Second, in most cases, they can’t be called before maturity. This is an annoying feature of corporate and municipal bonds.

Third, Treasuries, at least until recently, have been considered the best-quality issues in the world. This was clear in 2008, when 30-year Treasuries returned 42%, but global corporate bonds fell 8%, emerging market bonds lost 10%, junk bonds dropped 27%, and even investment-grade municipal bonds fell 4% in price.

Stocks way, way underperformed Treasury bonds in the 1980s and 1990s in what was the longest and strongest stock bull market on record. The superiority of Treasuries has been even more pronounced since then.

We expect the rally in Treasury bonds to continue in the second half of 2010. The eurozone crisis, now in reprieve, seems likely to heat up again. Weaker US economic growth should be a reality and shows every indication of persisting into 2011, with another recession a growing possibility.

Unemployment is likely to remain near the 10% rate and consumer spending weak as Americans no longer have federal stimulus increasing their incomes but persist in saving more of what they do earn.

And deflation may become established in the second half of this year. Already, the CPI and PPI excluding food and energy are running about 1% inflation rates year over year, below the Fed’s informal target of 1.5% to 2.0%.

We continue to look for 30-year Treasury bonds to rally to 3% yields as slow economic growth of about 2% prevails and chronic deflation sets in.

At 3% yields, "the bond rally of a lifetime" would be over, but with 2% to 3% deflation, the resulting 5% to 6% real returns for the best credits in the world would still be very attractive.

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