Seeking Alpha contributor Eric Parnell recently wrote an article in which he stated that given the Fed's extension of Operation Twist, maintaining exposure to long-term Treasuries is a good idea. A quick excerpt:
Thus, it appears as if the U.S. Federal Reserve through Operation Twist has finally identified a way to try and stimulate the economy, while also lowering yields and borrowing costs as a result.
For these reasons, maintaining exposures to long-term U.S. Treasuries is likely to be beneficial moving forward.
While I have great respect for Eric Parnell and his generally solid macroeconomic analysis, I'm going to have to disagree with him on this one. Bernanke's policies are not bond-friendly. Long-term Treasuries are a risky play right now, and there are several factors to keep in mind.
1: Yields Have No (Significant) Room To Drop
2: Operation Twist Not Responsible For Yield Drop (Europe Is)
In the article, Parnell makes the point that Treasuries did fairly well after Operation Twist commenced last fall, and thus, they can be expected to do the same again. However, this argument assumes that all conditions are equal -- which they are not.
Analyzing real (inflation-indexed) yield rates from the Treasury, you can see that the real yield rate in Sep '11 when Twist commenced was 98 basis points (0.98%) for a 30-year bond. Today, the real yield is 57 basis points (0.57%). While it's possible that rates could be pushed a little lower in the coming months, there's far less upside than downside risk. I believe it's highly unlikely that investors will look favorably upon 30-year bonds with a negative real yield. The flight to Treasuries has been mostly a product of fear trading based on bad economic data from the US and the whole euro mess -- but one whiff of good news, and people will abandon Treasuries in favor of stocks. It wasn't Operation Twist that drove yields down in general. Rather, it was fear trade, which can't last forever. Again: it's important to realize that this is purely fear trade, as yields have hit the same levels they did post-2008 crisis. See the chart below.
click to enlarge image
It's also interesting to note that the record low for real yields was set on June 1st, when inflation-adjusted yields on the 30-year bond fell to 36 basis points (0.36%). Furthermore, this week began with real yield at 49 basis points, and ended at 57 -- on 6/20/2012 (date of the Fed announcement), the real yield was 0.50%. Why'd it jump 7 basis points?
A look at history answers that question. An analysis of the original Operation Twist in the 1960s shows something interesting: Operation Twist doesn't necessarily reduce long-term borrowing costs in absolute terms, and Bernanke knows that. In fact, it slightly increased long-term borrowing costs in absolute terms. Operation Twist just flattens the yield curve, reducing long-term borrowing costs relative to short-term borrowing costs. With yields at record lows, I find it highly unlikely that any significant further reduction in yields will occur. Again, there's always a possibility it might go a bit lower -- but the opposite is much more likely. In any circumstances that bolster investor confidence (resolution of the fiscal cliff, progress in Europe, good jobs report), investors will flee Treasuries for higher-yielding investments.
(Blue chip stocks like PepsiCo and Procter & Gamble currently have higher dividend yields than 30-year Treasuries -- and unlike 30-year Treasuries, these investments have significant upside if and when economic expansion occurs.)
3: Quantitative Easing Still On The Table
Parnell's analysis also suggested that QE is unkind to Treasuries, because if quantitative easing occurs, investors go risk-on and drop Treasuries for stocks and other higher-return assets. Unfortunately for bond investors, this results in somewhat of a damned-if-you-do-damned-if-you-don't-scenario. Here's why.
Above, I established that if positive economic data presents, investors will flee Treasuries for risk-on assets. However, even though Bernanke didn't announce additional easing now, he has a strong easing bias:
"Additional asset purchases would be among the things that we would certainly consider if we need to take additional measures to strengthen the economy," Bernanke said.
So essentially, holders of long-term Treasury bonds are in a pickle either way. If the economy continues to spiral down, Uncle Ben will step in with QE -- which is great for stocks, but not so much for bonds. If the economy does well, however, Treasury yields will rise as investors demand more parity between bond yields and stock dividends. Either way, anyone buying into long-term Treasuries right now will be underwater very soon.
Conclusion: Stay Away From Treasuries
I really, really, really don't like Treasuries, for reasons I've outlined here. (The Impending Collapse of the Treasury Bubble.) My view is similar to that of Jim Kochan, the chief fixed-income strategist at Wells Fargo:
"There are not many places for value in fixed income lately," Kochan says. "Europe, not Operation Twist, is responsible for keeping interest rates down," Kochan says. "The Fed doesn't have to do anything, the Europeans have done it for them."
He says Treasury yields are too low to warrant any investor interest, as are yields on just about anything closely associated with Treasuries. He calls agency mortgage-backed security spreads "fair at best" and says TIPS "should be sold - there's just no value there."
Kochan goes on to recommend high yield bonds and municipal bonds instead. So out of Parnell's recommendations (Agency Mortgage Backed Securities (MBB), Build America Bonds (BAB), and Municipal Bonds (MUB), U.S. Treasury Inflation Protected Securities (TIP), and bond funds like TLT), I'd only be comfortable approaching MUB. Ironically, I feel much safer in high-yield bonds (HYLD) and stocks right now than I do in Treasuries. Short-term Treasuries (2-5 years) are okay for parking cash in, but the longer term bonds are subject to significant interest rate risk.
For investors wanting current income and hedging against the stock market, I'd recommend the following strategy. Buy solid defensive blue chip dividend stocks yielding 3% or higher, then use a covered call writing strategy to pocket another few percent. This has two benefits: first, you receive a higher level of current income than you do by investing in Treasuries, without the interest rate risk. Second, you position yourself for significant upside when the recovery kicks off.
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