From the October 2010 issue of Research Magazine • Subscribe!

October 1, 2010

Will Treasuries Plunge?

How to hedge against plunging Treasuries.

With the Federal Reserve reiterating its stance on a low interest rate environment, falling bond yields have been a major investment theme so far this year. The benchmark 10-year U.S. Treasury yield, which went as high as 3.99 percent in April, sank to 2.62 percent in August. Lower income payouts have given bond investors plenty to complain about, but the decline in yields has led to a massive rally in bond prices. Is a major correction coming?

Government bond ETFs, especially ones with maturities longer than 10 years, have enjoyed the run by soaring to new heights. Among long-dated Treasury ETFs, the iShares Barclays 20+ Year Treasury Bond Fund (TLT) is up 22.28 percent, the Vanguard Extended Duration ETF (EDV) is ahead by 32.99 percent and the Direxion Daily 30-Year Treasury Bull 3x Shares (TMF) has soared 72.21 percent year-to-date (figures are through the Aug. 30 market close). Are more gains ahead or is the best over?

Despite talk of a debt bubble, yields on U.S. government Treasury bonds are in line with those in the developed world. The record lows on yields for Japanese government bonds (JGBs) are 0.5 percent on 10-year and 1.0 percent on 30-year debt. The yields of the JGBs are in the process of retesting those lows that were set in 2002 although Japan is carrying a national debt that is some 200 percent of its GDP.

Interestingly, China is buying up JGBs to diversify out of U.S. Treasuries. Low yields haven't discouraged creditors even while the Bank of Japan has been printing money to avoid losing its export edge.

Where do China and other creditors park their money elsewhere if not in U.S. Treasuries? Euro-denominated debts may be worse than U.S. Treasuries. The euro zone is still printing money in order to fight deflation, and the supplies of new money are increasing consistently. The U.S. is certainly in terribly bad financial shape; however most of the other developed nations are not any better.

Piling into Bonds

Over the past decade, the American public has participated in and experienced its fair share of financial bubbles. The meltdown in technology stocks along with the subsequent collapse of the housing market victimized millions. But instead of learning from these mistakes, people seem to repeat them.

The Investment Company Institute confirms this trend. Bond funds raked in $559 billion from January 2008 to June 2010 while over the same period stock funds had outflows of $232 billion. "I'm not a market-timer. However, based on new research that follows ETF cash flow, this is a very bullish sign for equities," notes Richard Ferri, CFA and president of Troy, Mich.-based Portfolio Solutions. Indeed crowd behavior is becoming more and more apparent in the bond market.

Treasury Credit Risk?

What about a government that racks up huge deficits, like the U.S.? This year's budget deficit is estimated to surpass $1.4 trillion, or 9.1 percent of GDP. According to the annual report by the Financial Management Service, a bureau of the U.S. Treasury, the government's entitlement programs such as Social Security and Medicare are facing a deficit over the next 75 years of $45.88 trillion. Would you want to lend money at today's rock bottom interest rates to a borrower facing these sorts of financial liabilities?

As the balance sheet of the U.S. gets weaker and economic problems persist, it would be reasonable to assume that creditors demand a higher yield. While this hasn't happened just yet, there are early warning signs that the times of cheap money for the U.S. government is over.

In reference to China's $900 billion stash in U.S. debt, Premier Wen Jiabao last year stated: "Of course we are concerned about the safety of our assets. I would like to call on the United States to honor its word, stay a credible nation and ensure the safety of Chinese assets."

Since then, the U.S. government's financial condition has worsened. The writing on the wall points towards higher yields (and falling prices) for U.S. Treasury debt. At what point will all of this debt become unserviceable?

Rewriting Textbooks

The great irony here is that Treasuries are usually viewed as the least riskiest of investments. Historically, that's been true from a credit safety angle where debt defaults by the U.S. government are still considered by many experts to be a long shot. Of course, sovereign governments can avoid defaulting on bonds by simply printing money to pay off their debt. But printing money comes with its own unique set of financial risks by devaluing currency and inviting inflation along with higher interest rates.

Even though the credit crisis of 2008 is history, dislocations within the bond market are hardly over.

In March, swap spreads on 7-year and 10-year treasuries and their equivalent corporate bonds turned negative for the first time ever. At that precise moment, the market thought U.S. corporate debt was less risky than U.S. government debt. That might qualify as one of this year's top five Black Swan events. This odd phenomenon ought to give professors plenty of material for rewriting finance textbooks. But for investors, it could be the sign of more unusual occurrences in the government debt markets.

Conclusion

It's undeniable that U.S. government bonds are an important asset class and that well-diversified portfolios should have some exposure to them. However, it's conceivable that some client portfolios now have way too much exposure to government bonds because of the run-up in bond prices or hot money chasing performance. How should you respond?

Work with your clients and help them to analyze their bond holdings to verify that their target asset allocation hasn't gotten out of whack. Most clients have trouble understanding that Treasuries are not immune to losses. Help them to remember that what goes up must come down. And show them that once today's low interest rate cycle has fully exhausted itself, higher borrowing rates will resume. In this particular regard, the price of Treasuries with long-dated maturities are sure to be hit very hard since they're most sensitive to movements in interest rates.

There are many ways to hedge your clients' portfolios for falling Treasury prices and higher rates. And now is probably the time to do it. Buying protective put options on Treasury ETFs is one choice or investing in short-term insurance via leveraged ETFs that move in the opposite direction of Treasury bond prices is another.

In any event, your clients will thank you for having enough sense to plan ahead. As the great Wayne Gretzky, observed, the key to winning is skating to where the puck is going, not where it's been. Isn't successful investing the same?

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