Treasuries Doomsday Is Four Years Away for Vanguard
Vanguard Group Inc., whose $148.2 billion of Treasuries makes it the largest private owner of U.S. debt, says the nation has until 2016 to contain its borrowings before bond investors revolt and drive up interest rates.
“In the absence of a long-term credible plan, we are somewhere around four years away on where the markets are going to say ‘enough is enough,’” said Robert Auwaerter, head of the Valley Forge, Pennsylvania-based Vanguard’s fixed-income group since 2003 and who this year was inducted into the Fixed Income Analysts Society Inc.’s Hall of Fame.
The U.S. has avoided the turmoil rocking Europe, where five nations have sought bailouts as their borrowing costs soared because investors boycotted their bonds. Instead, they have sought U.S. assets as a haven due to the dollar’s status as the world’s primary reserve currency, pushing note yields to record lows even though the amount of public debt outstanding has grown to $15.9 trillion from less than $9 trillion in 2007.
Demand for U.S. bonds and the dollar has bolstered President Barack Obama’s ability to fund a budget deficit forecast to exceed $1 trillion for a fourth straight year, and helped Federal Reserve Chairman Ben S. Bernanke’s efforts to keep borrowing cost low. The greenback makes up 62.2 percent of all currency reserves, compared with 24.9 percent for the euro, according to the International Monetary Fund in Washington.
“The U.S. Treasury gets a pass, in part because the liquidity in that market brings buyers in that would maybe not be there if there was a viable alternative,” Auwaerter, 56, said in a recent interview at Vanguard’s headquarters, where he oversees about $675 billion of fixed-income assets.
Vanguard’s flagship bond fund, the $110 billion Total Bond Market Index Fund, returned 6.98 percent over the past five years, beating 64 percent of its peers, according to data compiled by Bloomberg. The world’s largest bond fund, the $263.4 billion Pimco Total Return Fund (PTTRX), which unlike Vanguard’s is actively managed, gained 9.44 percent in the same period.
The 10-year Treasury yield fell six basis points, or 0.06 percentage point, last week to 1.49 percent, according to Bloomberg Bond Trader prices. The 1.75 percent note due May 2022 rose 18/32, or $5.63 per $1,000 face amount, to 102 12/32. The yield was 1.45 percent at 10:21 a.m. New York time.
The yield, which touched a record low of 1.44 percent on June 1, is down from this year’s high of 2.4 percent on March 20 as global growth slowed and compares with the average of 4.88 percent over the past two decades.
Even with record-low yields, Treasuries maturing in 10 years or more have returned 7.4 percent this year, including reinvested interest. The Standard & Poor’s 500 Index (SPX) of stocks has gained 9.1 percent, including dividends, and commodities as measured by the S&P GSCI Index have lost 3.6 percent.
Investors aren’t getting paid enough for the risks of holding the debt, Elaine Stokes, a money manager at Loomis Sayles & Co., who helps oversee the $21 billion Loomis Sayles Bond Fund (LSBDX), said in a July 11 telephone interview.
“There’s very little upside, but there’s all kinds of downside,” Stokes said. “There’s a finite timeline to some of the issues that we’re facing. It’s no longer that we can keep kicking the can down the road,” she said in reference to lawmakers who keep raising the nation’s $16.4 trillion debt ceiling instead of reducing borrowing.
Investors would lose $1.08 million, or 10.8 percent, for every $10 million invested in 10-year Treasuries if yields were to rise to 3.8 percent by December 2014, the average for the past decade. Loomis Sayles sees yields between 2 percent and 2.5 percent a year from now.
The term premium, a model created by the Fed that includes expectations for interest rates, growth and inflation, showed Treasuries are the most expensive ever. The gauge fell to a negative 0.9617 percent on July 10 from negative 0.2265 percent in July 2011. It averaged positive 0.8579 percent in the decade before the start of the financial crisis in mid-2007.
With $1.9 trillion, Vanguard is the largest mutual-fund manager in the U.S., having grabbed the top spot from Fidelity Investments in 2010. Its Treasuries holdings rank ahead of Newport Beach, California-based Pacific Investment Management Co., with $110.2 billion, data compiled by Bloomberg show.
The firm ranks ahead of Russia and just behind Switzerland as the eighth-largest U.S. creditor. The Fed, with $1.66 trillion, is the biggest, followed by China at $1.15 trillion and Japan with $1.07 trillion.
Auwaerter joined the company in 1981 to manage municipal bonds and money market funds. He now oversees a staff of 115, who are called crewmembers in keeping with a firm named for HMS Vanguard, one of British Admiral Horatio Nelson’s flagships. He spends his work days in the middle of a 5,400-square foot (1,700 square-meter) trading floor in a building called Victory, named for Nelson’s flagship at the Battle of Trafalgar in 1805.
“There’s constant interaction,” he said. “We argue about things with the idea that everybody can be challenged on any viewpoint.”
With a bachelor’s degree in finance from the University of Pennsylvania’s Wharton School and a master’s in business administration from Northwestern University’s Kellogg Graduate School of Management, Auwaerter has during his career testified before Congress on matters pertaining to the fixed-income market and trading.
“He’s been through a lot of difficult markets over those 30 years,” said Stephen Lessing, global head of senior relationship management in New York at Barclays Plc, a 32-year bond-market veteran who first met Auwaerter in 1981.
Congress will have to work with the winner of this year’s presidential election -- Obama or presumptive Republican challenger Mitt Romney -- to pass a plan within three to five years that puts the U.S. on a path toward sustainable budgets, Auwaerter said.
“With health care plus the demographics of the Baby Boom generation and the pressure that’s going to put on Social Security, all those things are going to come to a head over a three-to-five year time frame,” he said. “In a three- to five- year time frame the market can start to look at us like an Italy or Spain and start to assess a credit risk premium to U.S. Treasury yields.”
In Italy, whose more than $2 trillion of marketable debt outstanding ranks as third-most behind Japan and the U.S., yields on 10-year bonds have soared to more than 6 percent from less than 4 percent in October 2010. The spread to benchmark German bunds has widened to about 4.8 percentage points from about 1.5 percentage points in that period.
With taxes set to rise and spending cut by $1.2 trillion if Congress fails to agree by Dec. 31 on ways to reduce the deficit, the so-called fiscal cliff facing the U.S. might imperil an economy that is already slowing. The International Monetary Fund cut its 2013 global growth forecast to 3.9 percent today, down from 4.1 percent in April.
Goldman Sachs Group Inc. and Bank of America Corp., two of the 21 primary dealers of U.S. government securities that trade with the Fed, say the central bank will likely keep its benchmark rate at almost zero until mid-2015. Credit Suisse Group AG, another primary dealer, said in a report July 13 that 10-year yields will end next year at about 1.75 percent.
“The threats of what could drive rates higher have been out there for a long time and has not inhibited us from getting to this stage of the game,” David Ader, head of U.S. government bond strategy at CRT Capital Group LLC in Stamford, Connecticut, said in a telephone interview July 9. “The global economy is slowing and the dollar looks like the least pathetic thing and that’s going to keep bond flows coming in. This is where we are going to be: low rates for a long, long time.”
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