Considering Treasuries? 2 Reasons To Reconsider

Includes: IPE, STPZ, TLT
by: Russ Koesterich, CFA

U.S. Treasury bond yields keep going down, while the risks are rising. While this asset class keeps getting bids, I believe there are more attractive options out there that offer less risk and better returns than the U.S. Treasury.

Earlier this year I wrote about the growing dominance of the Fed, and other public institutions, in the U.S. Treasury market. As I discussed at the time, research by my colleague Antti Petajisto showed that in 2011 the Fed, along with international public sector buyers, took down more than 100% of the new supply of Treasuries of 5-year maturities and over. With Treasury yields hitting an all-time low of 1.40% in July, it should come as no surprise that this trend has continued into 2012.

Through its extension of Operation Twist, the Fed continues to purchase roughly $45 billion of long-dated Treasuries each month. In addition, foreign official sector buying has also kept pace with recent patterns. As a result, the Treasury market is passing a significant milestone: The Fed will soon own more long-term Treasuries than the entire private sector.

There are two major implications for this structural change in the market for U.S. long-dated debt:

  • First, there is an ever-shrinking supply of high-quality debt available for the private sector. With Europe still mired in recession and with no clear path to fiscal union, the number of AAA-rated issues globally is declining. With the United States one of the few remaining countries whose bonds are mostly AAA-rated, many institutional investors are effectively compelled to own these bonds, regardless of their view of the long-term value.
  • Second, with the private sector receding from this market, the typical metrics that investors used to gauge the direction of the Treasury market have been rendered largely irrelevant. Historical measures of value or signs of investor demand matter less when the marginal buyer is either a public sector institution, like the Fed, or a bank or insurance company that needs to own AAA bonds. In both cases, the buyer is less sensitive to the price.

While yields may remain low- or as long as the Fed is willing to maintain a bloated balance sheet- investors looking to maximize their returns should still be looking for alternatives. Even if rates don't rise, without a steep and prolonged drop in inflation, long-dated Treasuries are still yielding below the level of inflation. In other words, unless you believe we're headed toward Japanese-style deflation, investors are accepting a negative real-return to lend to an entity with deteriorating credit quality. In addition, with coupon payments so low, the duration or interest-rate risk of any given maturity has risen dramatically. Investors are not only acquiescing to low returns, but they are accepting more risk for the privilege.

I continue to believe there are better alternatives in the fixed income space. Specifically, I continue to like U.S. investment-grade and municipal bonds, both of which have outperformed the broader bond market year-to-date. For investors with higher income needs, high yield bonds also appear worthwhile. In short, the Fed or foreign central banks may have a motivation to overpay for U.S. Treasuries; private sector investors have better options.

Source: Bloomberg

Disclaimer: Bonds and bond funds will decrease in value as interest rates rise. High yield securities may be more volatile, be subject to greater levels of credit or default risk, and may be less liquid and more difficult to sell at an advantageous time or price to value than higher-rated securities of similar maturity. A portion of a municipal bond fund's income may be subject to federal or state income taxes or the alternative minimum tax. Capital gains, if any, are subject to capital gains tax.

Original post