Bond ETFs: Are Treasury Bonds Entering a Downtrend?

In the summer of 2007, the Fed found itself abruptly veering from its rate-raising course to slashing the rates borrowed by banks at the discount window. The help was temporary, as the word "subprime" and the phrase "credit crunch" dominated the headlines.

For 9 months, treasury bonds became the ultimate safe haven for fearful investors. Until March.

In March, the rules of the game changed more dramatically than a Democratic National Committee [DNC] decision on delegate seating. Specifically, the Fed orchestrated a bailout of Bear Stearns (BSC). In so doing, regulators are likely to get even more power to intervene in non-FDIC banking activity.

Good thing? Bad thing? That debate will play itself out in Congress and in the financial media over the next several years.

Nevertheless, the rule-changer that occurred in March has led to: (a) the firming up of the U.S. dollar, (b) greater interest in stock assets, and (c) less interest in treasury bonds.

In the chart below, one can see the inexorable rise in intermediate-term treasuries from June 07 to March 08.  Since then, investors have been selling treasuries. The 10-year note's yield has gone from 3.3% to 4.1%. And the iShares Lehman 7-10 Year Treasury Fund (IEF) may soon enter a technical downtrend.

Long-term treasuries have already fallen below a long-term trend. Indeed, the iShares Lehman 7-10 Year Treasury Fund may soon join its older brother, the iShares 20 Year Treasury Fund (TLT), on the "down low."

Granted, stock assets haven't exactly freed themselves from the bear's grip. Still, one has to be impressed by the willingness of individual and institutional investors to put sideline money to work.

Where might some of that money be going? Treasury debt is finding its way into high yield (junk) bonds.

Take a look at the general direction for the iShares Corporate High Yield Fund (HYG). Granted, it met with the same technical resistance as equities have in the last few weeks. Still, there appears to be some faith in U.S. companies and/or faith in the Federal Reserve to act quickly in the economy's best interest.

Where do bond ETF investors go from here? Some consideration should be given to the high-yield arena vis-a-vis the Corporate High Yield Fund. I made this case effectively in March.

Disclosure Statement: ETF Expert is a web log ("blog") that makes the world of ETFs easier to understand. Pacific Park Financial, Inc., a Registered Investment Advisor with the SEC, may hold positions in the ETFs, mutual funds and/or index funds mentioned above. Investors who are interested in money management services may visit the Pacific Park Financial, Inc. web site.

Comments

[Msrpaul:]

Other than shorting the TLT, the only other way I can play this trade is RYJUX. I have been looking at this trade for weeks now, and only avoided it because another "shoe" dropping will send equity scardicats back to bonds, thus my conclusion is shorting the TLT is the same strategy as going long stocks....and that really wouldn't be economic diversification, would it?

2008 May 30 09:00 PM

[goalposts:]

What about the TBT?

2008 Jun 01 11:03 AM

[bearfund:]

TBT and PST are available now, as goalposts noted. This is NOT the same as going long stocks, however. If you assume that "stocks" and "Treasuries" are the only two places money can be invested, you arrive at that oversimplified conclusion. But as the author points out, high-yield corporate paper is gaining traction, and unless you've been living under a rock for the past 5 years you know that commodities and precious metals are booming.

Take a step back for a moment and stop looking at Treasuries as the things people buy when they don't want to take risks. Instead look at the supply of Treasuries, the current real yields, the balance sheet and prospects of the issuer, and the currency in which the paper is denominated. Supply: $9.4T outstanding and multiple large auctions in the recent past and near future, with no realistic plan by the government to cut the deficit. Real yields: below the CPI increases through 5 years, well below the true rate of price growth at all maturities. Issuer's balance sheet and prospects: see above, plus a real possibility of recession with slow or no growth all but a given for the next few years. Currency: could go either way on this one; foreign investors might suppose that after falling 50% in 5 years the dollar can only rise from here, or they might argue that the fundamentals haven't changed a bit in that time and sooner or later the big holders are going to start cycling out dollars as they diversify their reserves.

Finally, the "safe haven" aspect really applies only to the short-term paper, especially 3-month bills. While the market still doesn't price much credit risk into long bonds (16 basis points on CDSs last I looked), there's plenty of interest rate and duration risk there, which seems to be the author's thesis. I'll go farther, though: I believe yields beyond 2 years will rise no matter what the Fed does from here. As I pointed out above, the fundamentals are awful. But Treasuries are in a catch-22; if the Fed raises rates, yields will rise with them as they normally do, but if the Fed fails to rein in money supply growth, foreign confidence in the dollar, shaky already, will simply crumble and even domestic buyers will find themselves unable to justify holding paper with a real yield so obviously far negative. And thus far the Fed's moves to offset the inflationary effects of their TAF and other manipulation have consisted of...wait for it... dumping tens of billions of dollars worth of Treasury paper!

Obviously, the picture is more complicated: dealers and financial institutions of all kinds use Treasuries for many purposes, most of which have nothing to do with believing the value of the bonds will increase or wanting the income they produce. Their reliance on these instruments isn't going to unwind overnight. But in time the market will come to realise that there are better-quality issues out there than these that can be used for spread trades, hedges, and reserves. And while that's happening in the dark corners of the financial system, the paper itself will look ever less attractive to even - and perhaps in time especially - the most risk-averse investors.

Where will that money go? What do you care, unless you're greedy and looking to double-dip? Maybe stocks (but which sector?), maybe oil (how much longer can this continue?), maybe gold and silver (looks awfully cheap given where real rates are, but there's a stigma attached), maybe food again (a convenient flood or drought might be the trigger), maybe foreign paper, maybe spread paper, maybe people's mattresses. It's a lot easier given the state of the economy (perilous) and the behaviour we see in the markets (nearly everything is overpriced) to identify obviously terrible investments and short them than it is to guess where a bunch of hot money borrowed for less than nothing will go next.

Raise rates, cut rates, leave rates unchanged; I don't care. There is no such thing as a free lunch, but as long as the government continues to believe this rule does not apply to it, shorting Treasuries is as close to it as you're going to get.

2008 Jun 01 01:13 PM

[sgt.red.blu...:]

I did the PCy Emerging Markets Sovereign debt, HYG U.S. Corprate High Yield and PFF Preferred fund in roughly equal position in April. Average blended yield is 6-7 percent. The PFF and HYG move with the stock market. PCy moves in its own orbit, while dollar hedged, it moves against the dollar.

2008 Jun 04 07:20 PM