Treasury Bear Will Worsen - Barron's

In Barron's cover story this weekend, author Andrew Bary says the bubble in U.S. Treasury bonds and notes has burst. Treasury yields are up more than 1.2 percentage points since the end of 2008, driving prices lower by 20%. Bary says yields, now 4.1%, could hit 5% by year-end.

To its credit, Barron's called a top in Treasurys at year-end, and it wasn't alone. In his annual letter to shareholders, Warren Buffett said that when the financial history of this era is written, the Treasury-bond bubble of late 2008 may be regarded as "equally extraordinary" to the dot-com bubble of the late 90s and the housing bubble earlier this decade.

Even with prices down 20%, Bary says Treasurys still look unappealing:

1. Yields are low by historical standards - as this chart demonstrates, the recent pullback has only brought yields back in line with 2003, which was itself a multi-decade low.
2. The government is issuing huge amounts of debt to fund record budget deficits - the Obama administration recently boosted its deficit projection for 2009 to $1.84T from $1.75T, and 2010 to $1.26T $1.17T; compared with a $458B gap last year. Total sales of government securities could hit $2.1T this year from $880B in 2008, and net sales could almost quintuple to $1.55T from $332B. A recent 30-year bond sale was poorly received. And global government issuance is way up, further inflating supply. The Fed is sopping up some of the deluge by buying back its own debt, but the program will end eventually, and if rates rise the Fed could be hit with losses of $140B or more.
3. The massive federal stimulus program ultimately may lead to much higher inflation - analysts believe inflation will remain contained in the short-term, but as health returns to the economy and inflation hits a conservative 2%, yields could go to 5.5% as investors seek an inflation-adjusted return of 3.5%.

But while the bear market in government Treasurys may continue, Bary says the bull market in corporate debt that started in March could go on. Junk bonds still look attractive at 15%, down from highs of 19.5%. High-grade corporates at 8%, a comfortable 4% above Treasurys, also look good. Muni bonds aren't as cheap as they were at the end of 2008, but they still offer reasonable returns of 4.5% to 5%. And if President Obama succeeds in lifting the top marginal income-tax rate to 39.6% from the current 35%, tax-exempt munis would benefit.

One way to short Treasurys is using ProShares UltraShort Lehman 20+ Year Treasury ETF (TBT), which should rise at twice the daily decline in the prices of long-term Treasurys. Treasury inflation-protected securities, or TIPS, which yield 1.62% (on the 10-year), and can be accessed through iShares Lehman TIPS Bond Fund (TIP), aren't the bargain they were at year-end, but they do offer protection from inflation.

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Here's some more commentary you may find useful:

• In an article today, Jeff Nielson contends muni yields will drop as the government steps in to help out municipalities and states teetering on bankruptcy by pressuring ratings agencies to bolster their scores.
• Tom Lydon's comprehensive summary of fixed-income ETFs this weekend is a good starting-point for investors looking to go long, or short.
• For those looking for a deeper understanding of the bond market and its day-to-day movements, John Jansen's highly-followed bi-daily summaries can't be beat.

Comments

[Hask]

I've invested a substantial amount in short and medium term muni bonds, high-yield corporates, and short term corporates. They have done well and I agree with the sentiments in this article that treasuries are in for some more contraction and that munis look promising. A 4% tax-free yield right now looks attractive.

2009 May 17 09:30 AM

[Jasper M]

I cannot comprehend loaning money to any of these classes of creditor. Corporate profits, for example, will not be immune to the ultimate impact on aggregate purchasing power of the housing collapse, and that seems doomed to drag out for years. A Lot of this money will Not get paid back.
And the current administration's willingness to tinker with bankruptcy law calls into question All recovery rates.

2009 May 17 09:28 PM

[doubleguns]

"government steps in.............. by pressuring ratings agencies to bolster their scores."

Again, manipulation. Have we not learned anything here. What is the value of rating agency scores any more. Who has faith that they are accurate. ANYTHING can get a AAA rating anymore.

Manipulating our way out of this problem is not going to get us down the road to prosperity.

It will be the road to financial hell.

2009 May 18 08:29 AM

[doubleguns]

"government steps in.............. by pressuring ratings agencies to bolster their scores."

Again, manipulation. Have we not learned anything here. What is the value of rating agency scores any more. Who has faith that they are accurate. ANYTHING can get a AAA rating anymore.

Manipulating our way out of this problem is not going to get us down the road to prosperity.

It will be the road to financial hell.

2009 May 18 08:29 AM

[hpcooperjon]

Government has good intentions. Saving trillions for the elite, they believe, will save the economy. At the risk of being trite, redundant, etc, I will say "the road to hell is paved with good intentions.

2009 May 18 09:25 AM

[The Geoffster]

The Fed is fighting nascent inflation scares with assurances that it can and will sop up excess liquidity at the appropriate time. I don't believe it. They will err on the side of caution to avoid squelching the recovery and may not be immune to political pressures to keep the gravy train rolling. Additionally, the politicians will want to inflate away the debt so they can keep on spending. Finally, there will be trouble finding foreign governments to buy our bonds as China seeks to establish a new reserve currency. TBT is a great way to play this trade.

2009 May 18 09:47 AM

[User 305589]

Are 10- and 30-year Treasuries too expensive? Sure. Will they collapse? Sure. Will it happen this year or next? Not so sure. Not by a long shot. Odds are that they will collapse violently, though much later than most people think. And they could rise to higher levels than even those seen by the end of 2008. Just look at Japan if you can't believe that a AAA rated govt bond cannot rally to seemingly absurd levels AND STAY THERE for years and years..And don't forget, shorting Treasuries has a negative carry, so you keep losing money as long as the downward move doesn't occur. So being early in this case, as often, equals being wrong, not to speak of the opportunities lost elswhere while having funds stuck up in a short treasury bond 'trade'.

All the arguments citing a weak economy and a prolonged subdued growth environment are imho absolutely correct as are the concerns about the balooning public debt and the Fed's printing press. However, think these arguments through: If we see indeed a prolonged period with little or no economic growth, with high unemployment and large public deficits how appealing do the alternatives to treasuries look? common stocks? with depressed profit margins at best and mounting losses at worst?
corporate bonds? better than equities but far from riskless and defaults will mushroom. foreign stocks? hm, possibly, but i don't buy the 'china pulls the world out of the slump'-argument. in all fairness, some foreign stocks may do better than u.s. equities but all in all not by much. And foreign government bonds and foreign currencies in most cases aren't in a much better position than those of the U.S.
Bottom line: Once this stock market rally has run its course and markets catch up with a worse-than-expected reality, many investors, especially institutions, will face the dilemma of where to put the funds. You don't pull out of treasuries in such an environment, rather, you keep what yopu have and add more till things really improve. Most people simply overlook this aspect. betting on a further substantial drop of U.s. Treasuries will be correct - long term. Short them though, it is essentially a bet on a quick and strong economic recovery. Such a bet is imho misplaced and therefore shorting treasuries HERE and NOW is premature.

2009 May 18 10:18 AM

[cyclingscholar]

Stop recommending TBT as a vehicle to short treasury bonds...except for the most liquid and short term of traders, day traders. TBT rebalances their portfolio DAILY, so the management fees are over 3% a MONTH....for you mathematically illiterate public high school graduates, that is 42.5% ANNUALLY. Think ya can swim against a tide of expense like that? I got some CDOs and land in florida ya might wanna buy......

cyclingscholar

2009 May 18 10:47 AM

[The Geoffster]

Investors need to read the prospectus on these levered inverse funds. They are indeed trading vehicles


On May 18 10:47 AM cyclingscholar wrote:

> Stop recommending TBT as a vehicle to short treasury bonds...except
> for the most liquid and short term of traders, day traders. TBT rebalances
> their portfolio DAILY, so the management fees are over 3% a MONTH....for
> you mathematically illiterate public high school graduates, that
> is 42.5% ANNUALLY. Think ya can swim against a tide of expense like
> that? I got some CDOs and land in florida ya might wanna buy......
>
>
> cyclingscholar

2009 May 18 11:02 AM

[Living4Dividends]

Great article, Eli !

You said: "A recent 30-year bond sale was poorly received. And global government issuance is way up, further inflating supply. The Fed is sopping up some of the deluge by buying back its own debt, but the program will end eventually, and if rates rise the Fed could be hit with losses of $140B or more"

It is amazing that even with the Fed vigorously printing money and using it to buy back it's own debt - that it STILL can't sop up supply. The strategy of monetizing the debt isn't working out too well for the Fed.

Simply amazing !

2009 May 18 12:08 PM

[Living4Dividends]

I can't believe TBT has such high fees. Where did you get this data?


On May 18 10:47 AM cyclingscholar wrote:

> Stop recommending TBT as a vehicle to short treasury bonds...except
> for the most liquid and short term of traders, day traders. TBT rebalances
> their portfolio DAILY, so the management fees are over 3% a MONTH....for
> you mathematically illiterate public high school graduates, that
> is 42.5% ANNUALLY. Think ya can swim against a tide of expense like
> that? I got some CDOs and land in florida ya might wanna buy......
>
>
> cyclingscholar

2009 May 18 12:11 PM

[Living4Dividends]

Given the tarnished reputation of the ratings agencies, you think the LAST thing the Govt would want to do is tarnish the reputation even more.

On May 18 08:29 AM doubleguns wrote:

> "government steps in.............. by pressuring ratings agencies
> to bolster their scores."
>
> Again, manipulation. Have we not learned anything here. What is the
> value of rating agency scores any more. Who has faith that they are
> accurate. ANYTHING can get a AAA rating anymore.
>
> Manipulating our way out of this problem is not going to get us down
> the road to prosperity.
>
> It will be the road to financial hell.
>

2009 May 18 12:13 PM

[Living4Dividends]

TBT is a bad idea. I also believe that buying futures on treasuries is also a bad idea. If I wan tto short something I will physically short it (not just buy options)

Is there anyway the average investor can truly short treasuries??

I heard this was not available to the retail investor.

On May 18 10:47 AM cyclingscholar wrote:

> Stop recommending TBT as a vehicle to short treasury bonds...except
> for the most liquid and short term of traders, day traders. TBT rebalances
> their portfolio DAILY, so the management fees are over 3% a MONTH....for
> you mathematically illiterate public high school graduates, that
> is 42.5% ANNUALLY. Think ya can swim against a tide of expense like
> that? I got some CDOs and land in florida ya might wanna buy......
>
>
> cyclingscholar

2009 May 18 12:21 PM

[igggy]

As someone mentioned above, people don't seem to want to look at Japan for whatever reason. They also forget that the money the Fed is printing is only replacing the easy credit that used to be out there. I recommend shorting TBT on any further drop in treasuries. Among other things you will benefit from the leverage-based erosion in TBT even if yields stay flat but there is some volatility. The only problem it might be tough to locate TBT shares to short.

2009 May 18 01:46 PM

[Living4Dividends]

Everyone seems to compare the U.S. situation to the same crisis Japan experienced two decades ago. There are fundamental differences between Japan's economy and ours. The comparison can't be made. We won't turn out like Japan, because we aren't like Japan.

On May 18 01:46 PM igggy wrote:

> As someone mentioned above, people don't seem to want to look at
> Japan for whatever reason.

2009 May 19 08:27 PM