Since the beginning of the year, it’s been a “Tale of Two Cities” for U.S. stocks and long-term U.S. Treasuries. Equity ETFs like the Vanguard Total Stock Market ETF (VTI) have risen swiftly, while the long-term Treasury ETFs like the iShares Barclays 20+ Yr Treasury Bond ETF (TLT) have fallen swiftly.
On the fundamental side, Chinese investors have been cutting their Treasury holdings, and the Federal Reserve’s massive shift from short-term to long-term Treasuries is ending in June. On a technical basis, long-term Treasuries have been trading below key technical levels like their 50-simple day moving average. What lies ahead for long-term U.S. Treasuries?
Since 2008, the Federal Reserve has taken drastic steps to keep interest rates from skyrocketing. The Fed has held benchmark interest rates between zero and 0.25% over the past three years and pledged to keep them there through 2014. In another financial maneuver aimed at jumpstarting the economy, the Fed gobbled up $2.3 trillion in mortgage securities and government bonds. Treasury bonds, particularly long-dated issues with 20-plus years until maturity, reacted by surging. In 2011, the iShares Barclays 20+ Yr Treasury Bond ETF (TLT) gained almost 34% in value.
Europe’s sovereign debt crisis helped to boost long-term Treasury prices too, as global investors favored the perceived safety of U.S. government debt over European rivals.
“Treasury yields are being repressed by the Fed and by exorbitantly high levels of risk aversion — neither factor is sustainable in the long term,” said James Kostohryz, CEO and global investment strategist at JK Advisory Services in Cartagena, Colombia. For this reason, he warns against owning Treasuries, especially with longer maturities.
The phenomenon of suppressed yields hasn’t stopped income starved investors from snapping up long-term Treasuries. In an effort to squeak out a few extra basis points of yield, they’ve fled money market funds, which carry even more depressed yields. But in an effort to help themselves, these same investors — “yield hogs” as they’re called — likely have purchased their Treasury bonds at the top.
A strengthening economy puts a damper on hopes the Fed will buy more U.S. debt through quantitative easing. It also makes the prospect of future gains in Treasury prices low. “Treasuries do not represent good value on any historical or even forward-looking measure,” added Kostohryz.
Inflation and Credit Risk
Last year the U.S. government lost its pristine credit score when Standard & Poor’s downgraded U.S. sovereign debt from AAA to AA+. Could this be the start of an ugly cycle of declining creditworthiness for Washington D.C.?
While the extent of the downgrade is minor, the implications are major. As the 2011 debt ceiling negotiations underscored, the U.S. cannot run its day-to-day operations without borrowing money. It lives on credit (as do most countries in the world today) and anything that impacts its ability to borrow money has serious consequences.
“We believe that our country is in an admirable position with its strong credit rating, but credit ratings are becoming more about math than perception, and the statement on the U.S. dollar about ‘in God we trust’ is vulnerable,” said Daniel K. Weiskopf III, principal of global ETF atrategies at Forefront Capital in New York. “Our long term concern is that we as a debtor nation are handicapping our future generations.”
History shows that escalating governmental debt can be a significant factor in slower long-term growth and/or higher inflation. In either scenario, Weiskopf believes Treasury investors stand to lose out, and thus he has avoided long-term Treasuries as part of his fixed income strategy.
Weiskopf adds: ”Retirement investors, have been lulled into believing over the past 30 years that fixed income portfolios are very safe and forget that the risk/return ratio on a piece of paper that offers a 2% income stream has the potential to be very damaging to a portfolio if interest rates go higher.”
Looking for Alternatives
To protect clients against future declines in long-term U.S. Treasuries, advisors should be proactive about looking for better opportunities elsewhere.
For market exposure to Treasury Inflation Protected Securities, the iShares Global Inflation Linked Bond Fund (GTIP) is an excellent substitute for a U.S.-only TIPS fund like the iShares Barclays TIPS Fund (TIP). GTIP diversifies its credit exposure among various investment grade countries like Canada, France and the United Kingdom. U.S. TIPS account for just 33% of GTIP’s market exposure. The average duration of TIPS within the fund is 11.79 years.
In some instances, financial advisors have been substituting investing grade corporate debt vehicles, like the iShares iBoxx $ Investment Grade Corporate Bond Fund (LQD), for U.S. government debt, reasoning that U.S. corporations have lower financial liabilities compared to the U.S. government.
Advisors who want a little more yield should consider the PowerShares Fundamental High Yield Corporate Bond Portfolio (PHB), which carries the attraction of higher yielding bonds but without the interest rate risk of longer dated debt. PHB includes a portfolio of 208 corporate bonds with a BBB/Baa credit rating or lower, Effective durations are 4.13 years and the fund charges annual expenses of 0.50%.
For actively managed ETFs that take a tactical approach to the bond market, the recently launched PIMCO Total Return fund (TRXT) offers an interesting opportunity. In each case, bond ETFs make a lot of sense, because they’re diversified, they have intraday liquidity, and rock bottom management fees.
Trading the Trend
Looking ahead, the bigger opportunity in the U.S. Treasury market could be on the short side. If that turns out to be true, than trading into inverse performing Treasury ETFs will be the way to profit.
As of mid-March, the ProShares Ultrashort 20+ Yr Treasury ETF (TBT) is already ahead 14.39% year-to-date and showing positive performance results over the past three months. TBT aims for 200% daily opposite performance to long-term Treasuries.
For more aggressive Treasury bears, the Direxion Daily 20+ Yr Treasury Bear 3x (TMV) aims for triple daily inverse performance of long-term Treasuries. And for less aggressive Treasury Bears, the Direxion Daily 20+ Year Treasury Bear 1x ETF (TYBS) aims for inverse daily performance to Treasuries without leverage.
In summary, the unraveling of the U.S. Treasury market could become one of the biggest investment events of our generation. And although we’re probably not quite there just yet, 2012 thus far looks like the start of an ugly road ahead for this particular investment category. •