From the March 2009 issue of Wealth Manager Web • Subscribe!

Treasury Strategy

Some market participants are concerned that as global financial markets normalize, investors will abandon low-yielding Treasuries in favor of more attractive options. Since most bond market portfolios have historically held a Treasury allocation, these concerns present a dilemma: Should investors continue to purchase Treasuries? Or should they reduce their holdings in expectation of higher rates in the future?

Although it is certainly possible that Treasury yields are poised for a sharp increase, there are several reasons why it may make sense for fixed-income investors to continue to maintain an allocation to Treasury securities. First of all, although Treasury yields are extremely low, there are
fundamental reasons for this. Second, research has demonstrated that predicting the future course of interest rates is exceptionally difficult, which calls into question the accuracy of predictions for future increases. The unique combination of safety and liquidity in Treasuries also provides benefits to a diversified fixed-income portfolio--above and beyond the return component. Finally, it may be possible to structure portfolios so as to minimize the impact of possible future rate increases.

Historically Low U.S. Treasury Yields

As I indicated earlier, there are fundamental reasons why Treasury yields have reached such low levels. As the global financial crisis prompted a flight to safety, investors abandoned risky asset classes in favor of ultra-safe U.S. Treasuries. The Federal Reserve also contributed to the Treasury rally by aggressively lowering interest rates. In fact, the Fed has set a 0% target for short-term interest rates and has stated that it expects to keep rates extremely low for the foreseeable future. The Fed may also purchase longer-dated Treasury securities in an effort to move these rates even lower.

Some economists and market participants also fear that the economy will suffer through an extended recession or even a depression. If these scenarios were to prompt a deflationary spiral, current Treasury yields might actually seem reasonable. If economic weakness persists or worsens, it is possible that yields on Treasury securities will remain extremely low for years to come.

While it is plausible that Treasury yields will remain low, there are equally good reasons why rates may rise sharply. The rally in Treasuries leaves little room for further
improvement. For instance, the yield on the two-year Treasury note has fallen from 5.25% to less than 1% since the credit crisis began in 2007. Furthermore, in order to fund higher levels of government spending, the issuance of Treasury securities has increased dramatically. In a traditional supply and demand relationship, increased issuance should lead to lower prices and higher yields. The actions of U.S. and international policymakers are also designed to create inflation and prevent a deflationary spiral. If policymakers succeed in re-inflating the economy, they may find it difficult to control future inflation levels. Higher inflation could lead to much higher interest rates in the future.

Predicting Interest Rates

Regardless of their market outlook, investors should carefully consider their ability to predict the future course of interest rates before altering their portfolio structure based on interest-rate forecasts. A significant body of academic research has demonstrated that correctly predicting interest rates over an extended period of time is virtually impossible. Studies published by the Federal Reserve Bank of St. Louis, economists at North Carolina State University, and the Journal of Applied Statistics indicate that most professional interest-rate forecasters fail to outperform a random walk approach. In other words, despite years of experience and access to the most sophisticated tools available, the forecasts of professional economists are less accurate than those obtained by flipping a coin.

Even the forecaster with the best track record failed to consistently outperform a coin flip when attempting to predict interest-rate changes. In order to be successful, portfolio managers must predict both future economic output and the manner in which other market participants will interpret this data. They must then forecast not only the direction of subsequent interest-rate moves, but also the magnitude and timing of the move. This is difficult to do correctly even once, and virtually impossible over a long period of time.

"Studies have shown that error statistics often double in size when the forecast horizon is extended as little as from one to two quarters ahead," the St. Louis Federal Reserve Bank reported. Once a forecaster makes a mistake, it becomes extremely difficult to recapture that lost performance.

Research indicates that investors should carefully consider whether they truly have a competitive advantage in forecasting interest rates before making a decision to avoid Treasury bond holdings that is based on their market forecast. This is especially true when the benefits that Treasury securities provide to a diversified fixed-income portfolio are considered.

The Role of Treasuries in a Fixed-Income Portfolio

Regardless of their interest-rate outlook, diversified fixed-income investors almost always hold some Treasury securities. In fact, it would be accurate to say that Treasury securities form the foundation of fixed-income portfolios. Although Treasuries are generally priced to yield less than other fixed-income securities, there are exceptions to this rule. In times of market turmoil--such as the present environment--Treasuries sometimes outperform other asset classes. In 2008, Treasuries (as measured by the Merrill Lynch Treasury Index) returned 13.98%, the best performance among major asset classes.

Treasuries are also considered to be free from default risk. As such, they add a safety component to fixed-income portfolios--a benefit that should not be minimized. Finally, the market for U.S. Treasuries is among the most liquid in the world. This is less important during normal market cycles when other types of fixed income also offer excellent liquidity. However, when liquidity evaporated from most other asset classes during the fall of 2008, Treasuries provided that much-needed liquidity.

One possible solution for some investors to counteract the possibility of higher interest rates is to shorten the average maturity of the Treasuries they hold. Because the yield curve is currently relatively steep, this would mean sacrificing current income. However, if rates rise sharply in the future, short-term Treasuries will outperform longer-term ones, and as these Treasuries mature, the proceeds can be reinvested at higher rates. Investors who choose to shorten the average maturity of their Treasury securities may still wish to maintain target duration in their portfolio. This can be accomplished by lengthening the average maturity of agency, mortgage, and corporate securities in order to offset the effect of shorter Treasury maturities. Although these other asset classes would also suffer in an environment of rising interest rates, their historically attractive valuations may provide more cushion than Treasury securities at record low yields.

Conclusion

While economic fundamentals have contributed to recent strong performance for Treasury securities, there is concern that current levels are unsustainable. Historically low yields, increasing supply, and potentially inflationary monetary policy have prompted concern that Treasury yields will rise sharply in the future. However, the challenging nature of successful interest-rate forecasting, combined with the safety and liquidity components, presents a strong argument for maintaining a position in Treasuries in a diversified fixed-income portfolio.

Brian Perry (brian.perry@chandlerasset.com) is a vice president and investment strategist at Chandler Asset Management in San Diego.

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