U.S. Treasury Blues: The Bond Bubble Has Burst

If the bond bubble has burst, then the safe haven is gold and silver and not munis, because the US dollar will be destroyed in the process. The Greatest Depression is here. Don’t forget to stock up food and water etc.

The bear market in Treasuries will worsen, because of a glut of government bonds. Instead, consider high-yielding mortgage securities and certain munis.

THE BUBBLE HAS BURST. We’re talking about U.S. Treasury securities, not housing. At the end of 2008, risk-averse investors poured into Treasuries, driving down yields to the lowest levels in decades. The 30-year Treasury bond fetched less than 3%, and short-term T-bills carried yields of zero.

Marc Burckhardt

Since then, the economy has shown signs of bottoming, the credit markets are functioning more normally, and the stock market has roared back from its March lows. Treasuries now are in a bear market, while bullish enthusiasm has taken hold in other parts of the credit market, including corporate bonds, municipals and mortgage securities, all of which had fallen from favor late last year. The 30-year Treasury, for instance, has risen to a yield of 4.10% from 2.82% at the end of 2008, cutting its price by 20%.

Barron’s called a top in Treasuries and a bottom in the rest of the bond market in an early 2009 cover story (“Get Out Now!” Jan. 5). We weren’t alone in recognizing some of the nutty year-end developments. Warren Buffett highlighted the sale in late 2008 by his Berkshire Hathaway of a Treasury bill for a negative yield. Buffett wrote in Berkshire’s annual letter in February that when “the financial history of this decade is written…the Treasury-bond bubble of late 2008” may rank up there with the housing bubble of the early to middle part of the decade. – How does the market look now? Treasuries still look unappealing for several reasons. Yields are very low by historical standards, the government is issuing huge amounts of debt to fund record budget deficits, and the massive federal stimulus program ultimately may lead to much higher inflation.

“There are better values elsewhere among high-quality bonds,” says Steve Rodosky, an executive vice president at Pimco, which runs the giant Pimco Total Return fund (ticker: PTTAX), the country’s largest bond fund; it’s besting its peers again this year, with a 4.8% return so far in 2009. Pimco’s chief investment officer, Mohamed El-Erian, was blunt at year’s end, saying, “Get out of Treasuries. They’re very, very expensive.”

While holders of Treasuries ultimately will get their money back, prices could fall sharply in the interim, and repayment could be in greatly depreciated dollars. Treasury yields may rise further in the coming year, meaning that prices will fall as the economy strengthens. The yield on the 30-year bond could top 5% and the 10-year note could rise to more than 4%, from a current 3.15%.

IF THE BOND-MARKET THEME of 2008 was a flight to quality, this year it has been flight from quality, as lower-grade, more speculative securities generally have generated the best returns. Returns on junk debt and lower-grade municipals have topped 20%, while the rise in government-bond yields has become a full-blown global phenomenon.

Even after rallying in recent months, the corporate-bond market looks attractive (please see story, “Corporate Bonds Are Back“). The average junk bond in the Merrill Lynch high-yield index has fallen to a still-lofty 15% yield, from 19.5% at year’s end, while more highly rated corporates — those with triple-B ratings — yield around 8%, a comfortable four percentage points above long-term Treasury rates.

The municipal-bond market also has advanced in 2009, with the yield on top-grade long-term securities falling to about 4.5%, from 5.25%, while rates on lower-rated securities like tobacco-revenue bonds and hospital debt, which topped 10% at year’s end, have dropped more than a percentage point.

High-grade, 30-year munis now look reasonable. At the end of last year, top-grade 30-year munis carried double the yields of 30-year Treasuries, an off-the-charts relationship. Now, the 4.5% yield on triple-A-rated long-term bonds is slightly higher than the yield on the 30-year Treasury.

That spread remains generous by historical standards. It is hard to get too enthusiastic about intermediate-term bonds with maturities of less than 10 years; they’re yielding 3% or less. Lower-grade munis could have more room to run.

The muni market could benefit if President Barack Obama succeeds in lifting the top marginal income-tax rate to 39.6% from the current 35%, because that would boost the appeal of tax-exempt interest income. State and local finances, however, are a mess throughout the country — particularly in California — due to a weak economy and the unwillingness of politicians to tackle the ballooning cost of pensions and health care for government workers.

It’s a tale of two markets in the mortgage-backed sector. There isn’t much appeal in government-backed Ginnie Maes — or in Freddie Mac and Fannie Mae securities, which carry an implicit federal backing. These securities yield just 4%. That means funds like the big Vanguard GNMA (ticker: VFIIX), now carrying a 4.3% yield, could have disappointing returns.

Treasuries have taken a pounding due to a glut of government bonds. But there are virtues in munis, says Barron’s Andrew Bary.

The riskier — and more attractive — part of the market is the so-called non-agency sector of home- and commercial-mortgage securities. These yields still can top 10%. Funds with exposure to the non-agency mortgage market include TCW Total Return (TGMNX), which has a current yield of 10%.

AMID THE DEBATE ABOUT THE direction of Treasury rates, one thing is clear: The recent rise in rates has merely brought the 10-year Treasury yield back where it stood in June 2003, when the prior, multidecade low in rates was reached.


“Bear Market in Treasuries Begins” was the title of a report last week from Morgan Stanley economists Richard Berner and David Greenlaw, who wrote about the “main culprit: a changing balance between credit supply and demand that is boosting real rates.”

The Morgan Stanley duo thinks that Treasury rates aren’t apt to shoot up anytime soon, because so-called core inflation, which excludes food and energy costs, is likely to remain around 1% for the time being and because “the economy is turning slowly.” Fresh concerns about the economy prompted a 4% selloff in the stock market last week, and a rally in the Treasury market, which tends to move inversely to stocks.

Looking out a few years, Berner believes that the 10-year Treasury could hit 5.5% as investors seek a real, or inflation-adjusted, return of 3.5%, relative to what may be 2% inflation. It’s no secret that the U.S. budget deficit is exploding this year from the combination of weak tax receipts and sharply increased spending. The Obama administration recently increased its deficit projection for the current fiscal year ending in September to $1.84 trillion, from the $1.75 trillion estimate made in February, and lifted its 2010 deficit estimate to $1.26 trillion, from $1.17 trillion. That compares with a $458 billion gap last year.

THE RESULT IS A LARGE INCREASE in the issuance of government bonds. Total sales of government securities with maturities of two years or longer are expected to hit about $2.1 trillion in the current calendar year, up from $880 billion in 2008, according to analysts at Barclays Capital. Net sales — issuance minus maturing debt — could hit $1.55 trillion, up from $332 billion last year. The growth in bond supply is particularly pronounced in seven-year, 10-year and 30-year maturities. One sign of trouble was the poor reception in a recent sale by the government of 30-year bonds.

The government-bond glut is hardly confined to America. Combined issuance in the U.S., Europe, Japan, Canada and Australia could come to $4.2 trillion this year, according to British financial historian and author Niall Ferguson. Net government-bond sales relative to gross domestic product will be particularly high in the U.K., at 17.9% — well above the lofty 12.7% here.

The U.S. Federal Reserve is trying to sop up part of the bond deluge with a program to buy $300 billion of government debt through the end of September. It has already purchased more than $100 billion. The Fed also has a program to buy $1.25 trillion of agency mortgage securities as part of an effort to depress mortgage rates, now averaging around 5%.

The Fed may succeed in artificially depressing Treasury rates for the time being, but the Fed program will end eventually, removing a key piece of support for the market. The Fed could get stuck with sizable losses if rates rise, since its holdings of bonds and mortgage securities, now $1 trillion, could double by the end of 2009. If rates rise one percentage point, the Fed could suffer $140 billion in losses, calculates Sean Kelleher, a partner at JGC Management, a New Jersey investment firm.

OVERSEAS DEMAND, PARTICULARLY from central banks, has supported the Treasury market in recent years, but that buying appears to be waning. China, for instance, sees sharply slowing growth in its foreign-currency reserves this year due to weakening exports, a development that reduces the country’s demand for Treasuries. Chinese officials also are worried about the country’s $1 trillion-plus holdings in Treasuries and other U.S. debt because of the risk of a weakening dollar and higher inflation.

One way to bet against the Treasury market is to buy the ProShares UltraShort Lehman 20+ Year Treasury ETF (TBT), which is designed to rise at twice the daily decline in the prices of in long-term Treasuries. This exchange-traded fund changes hands at around $50 a share, up from $40 at year’s end.

Treasury inflation-protected securities, or TIPS, appear to be a better bet than regular Treasuries, but they’re not the bargain they were at the end of last year. The 10-year TIPS yield 1.62%, and the 20-year TIPS, just 2.25%.


In addition to this real yield, investors’ principal is indexed to U.S. inflation. If inflation runs at 2.5%, the 10-year TIPS will return 4.12% (the real yield plus inflation), and the 20-year TIPS will return 4.75%. The yield gap between the TIPS and ordinary Treasuries is called the break-even rate. That’s the inflation rate that would result in similar yields on the two securities. The 10-year break-even rate is now about 1.5% (the 3.12% yield on regular Treasuries minus 1.62%), which is below the historical average of two points, but above the break-even yield of 0.20% at 2008’s end, when TIPS were very attractive relative to ordinary Treasuries as investors figured there might be deflation.

TIPS ARE STILL GOOD, BECAUSE they protect bond investors from what they fear most: inflation. Investors can play TIPS through the Vanguard Inflation-Protected Securities fund (VIPSX), or an exchange-traded fund, the iShares Barclays US Treasury Inflation Protected Securities fund (TIP).

The muni market has rallied sharply since March, helped by a new government program that allows state and local governments to sell taxable bonds for infrastructure and other needs while getting a federal subsidy for part of the interest expense.

Since March, some $9 billion of the Build America Bonds, or BABs, have been sold, including big deals from California and the New Jersey Turnpike Authority. BABs appeal to bond issuers because the all-in interest costs on the BABs now are lower than the cost of tax-exempt bonds after the federal interest subsidy of 35%. Estimates are that $50 billion to $100 billion of BABs may be sold this year, accounting for perhaps 25% of total muni issuance. The Obama-initiated program is due to last through 2010.

CALIFORNIA’S BABS THAT ARE DUE in 2034 and 2039 now yield about 7.5%, versus a 5.5% yield on the state’s long-term tax-exempt bonds sold in March. The all-in cost to California for the BABs is roughly 4.9% (7.5% times 0.65), below the cost of tax-exempt financing. The Golden State’s general-obligation bonds carry some of the highest yields among state GO debt, due to the state’s huge deficit, recently estimated at $15 billion, and an economic mess evident in a jobless rate of 11%.

Other high-yielding munis include so-called tobacco revenue bonds, which were sold by states and backed by payments made by cigarette companies under the Master Settlement Agreement in 1998. A long-term issue from Buckeye Tobacco, issued by Ohio, yields nearly 10%, and carries barely investment-grade bond ratings of Baa3 from Moody’s.

The Build America Bonds program has bolstered munis by diverting new supply into the taxable market. Traditional buyers of corporate debt have bought BABs because yields are high relative to corporate issues with similar credit ratings.

There also has been a record inflow to muni mutual funds so far this year, with $4 billion to $5 billion a month entering open-ended funds.

The situation in the bond market isn’t as extreme as it was at the end of 2008. Still, investors ought to avoid Treasuries, buy corporates and high-yielding mortgage securities — and consider municipals.

MONDAY, MAY 18, 2009

Source: Barrons

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