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Buy Treasuries, Sell Munis
01/19/2011 12:07 pm EST
Widely reviled Treasury bonds are set to outperform stocks and commodities in 2011, even as the exodus from the municipal debt market continues, writes Gary Shilling in INSIGHT.
Buy Treasury bonds. We’re deliberately listing this 2011 suggestion first not because of nostalgia, although this strategy has worked for us for 29 years on balance, and has been our most profitable investment. Instead, it’s because we expect further substantial appreciation with 30-year Treasury bonds, and because so few other investors believe our forecast has any chance of being realized.
- Because we foresee slow economic growth at best in coming quarters and years
- Because the Fed is determined to further reduce interest rates
- Because deflation is looming
- Because long Treasury bonds are attractive to pension funds and life insurers that want to match their long-term liabilities with similar maturity assets
- Because as the US moves ever closer to the slow growth and deflation of Japan, the parallel trends in government bond yields seem likely to persist
- Because Treasuries are the safe haven in a sea of trouble in the Eurozone and elsewhere
- Because China’s attempts to cool its economy will probably precipitate a hard landing
- Because the likely price appreciation in Treasuries is in stark contrast to expensive stocks and overblown and vulnerable commodities, foreign currencies, junk securities, and emerging market stocks and bonds.
We continue to predict that 30-year Treasuries, “the Long Bond,” will rally from their current yield of about 4.4% to 3%. A 30-year zero-coupon Treasury would gain 48%.
We also expect the ten-year Treasury note yield to drop from the present 3.3% to 2%, but the appreciation would be only 11%, largely because of its shorter maturity.
Most observers think our forecast is ridiculous, but then they’ve been skeptics ever since we said that “we’re entering the bond rally of a lifetime” in 1981, when the 30-year Treasury yield peaked at 15.21%.
[Shilling is right to note he’s bucking the consensus. Marilyn Cohen, Mary Anne and Pamela Arden, Doug Fabian, Roger Conrad, David Fried and Kelley Wright have all turned bearish on Treasury bonds—Editor.]
Munis Going to the Dogs
Municipal bonds, however, are in the doghouse and likely to remain there for some time. Since early last year, we’ve worried about the growing plight of state and local governments. Widespread municipal defaults are unlikely. In 2010, there were only five municipal bankruptcy filings, down from ten in 2009 and, through Dec. 1, they equaled $4.25 billion, or just 0.15% of the total muni market.
State revenues from sales and income taxes have revived a bit, but collective budget gaps of $160 billion in fiscal 2011 ending in June and $140 billion in fiscal 2012 remain as federal stimulus funds drop.
Local governments get a third of their revenues from hard-pressed states and a quarter from property taxes, which will undoubtedly fall as assessed values catch up with collapsed real estate prices with the usual three-year lag. Furthermore, New Jersey, Indiana, and some municipalities are belatedly following California’s Proposition 13 in 1978 in limiting property tax increases.
The December 2010 congressional tax act was another blow to the muni market. The extension of the Bush tax cuts made tax-free muni interest less valuable. The resulting higher deficit implied more financing competition from the Treasuries. And the Build America Bonds program was not renewed. It attracted pension funds and foreign investors to taxable munis that accounted for about $117 billion, or one-third of new muni issues, in 2010.
The yields on munis have jumped, not only in absolute terms but also in relation to Treasuries. From Nov. 1 to Dec. 17, the average yield on triple-A 30-year municipal bonds jumped from 3.36% to 4.66%. [The yield has jumped to 5.12% as of Tuesday—Editor.]
Institutional investors and individuals holding municipal bond mutual funds are heading for the exit. Of course, higher borrowing costs inflate budget deficits, requiring more borrowing and lower ratings in a downward spiral.
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