Bond Bears Snap Up Treasuries as Bets Cut by Most Since ‘09

PIMCO Co-chief Investment Officer Bill Gross
Bill Gross, co-chief investment officer of Pacific Investment Management Co. (PIMCO). Photographer: Scott Eells/Bloomberg

Eight months ago Bill Gross, manager of the world’s biggest bond fund, said Treasuries “may need to be exorcised” and cleaned them out of his $245 billion Total Return Fund. The company then used derivatives to bet against the debt in March.

Now the Pacific Investment Management Co. fund has 16 percent of its assets in U.S. government securities as the debt posted the highest quarterly returns in almost three years.

“We’ve rebalanced,” Mohamed A. El-Erian, chief executive officer and co-chief investment officer at Newport Beach, California-based Pimco said in a Sept. 27 radio interview on Bloomberg Surveillance with Tom Keene in New York. “The U.S. benefits the most from a flight to quality.”

With the economy growing slower than forecast, the biggest bond rally in three years has repudiated Standard & Poor’s Aug. 5 downgrade of the U.S. AAA credit rating and driven yields to record lows, prompting bears to play catch up in a bid to match indexes portfolio managers use to measure performance. Economists have cut their estimates for the 10-year yield in March 2012 to 2.56 percent, from a projection of 3.75 percent in July, the biggest cut since January 2009.

A Deutsche Bank AG measure of asset allocation among the 20 largest non-indexed funds indicates that since early August they have pulled close to even with the benchmark Barclays U.S. Aggregated index weighting of 34 percent in Treasuries.

Additional Demand

The funds Deutsche Bank tracks started “throwing in the towel” when 10-year yields fell to about 2.25 percent, Dominic Konstam, head of interest-rate strategy at the bank in New York, one of the 20 primary dealers that trade with the Federal Reserve, said in a Sept. 26 telephone interview.

Additional demand for Treasuries from fund managers may push the 10-year note yield to 1.25 percent, Konstam said.

As the likelihood grew that lawmakers in euro-member countries would approve an expansion of the European Financial Stability Facility, Treasury 10-year yields rose eight basis points, or 0.08 percentage point, last week as the price of the benchmark 2.125 percent security due August 2021 fell 24/32, or $7.50 per $1,000 face amount, to 101 27/32.

The two-year yield rose two basis points to 0.24 percent for the first consecutive weekly increase since April, even as investors bid $3.76 for each dollar of debt sold at a $35 billion action of the securities Sept. 27, the most in a year. Bids at the five- and seven-year note offerings the next two days were the most since May.

Below the Benchmark

Treasury 10-year yields declined five basis points to 1.86 percent as of 9:45 a.m. in New York. Two-year rates were little changed at 0.24 percent.

Treasuries returned 6.4 percent in the period from July to September, the biggest quarterly gain including reinvested interest since the last three months of 2008, Bank of America Merrill Lynch indexes show. Company bonds returned 2.26 percent and mortgage securities gained 2.32 percent, the indexes showed. The Barclays U.S. Aggregate bond index gained 3.9 percent for the quarter.

The Standard & Poor’s 500 stock index declined 14 percent while gold appreciated 7.8 percent. The dollar rose 5.7 percent in the last three months against a basket of currencies including the euro and the yen, according to IntercontinentalExchange Inc.’s Dollar Index.

The 1,095 taxable bond mutual funds that invest primarily in U.S. debt markets held an average 12 percent of assets in Treasuries last quarter, according to Chicago-based Morningstar Inc. Bets placed on U.S. debt using Treasury futures are not included in calculating the holdings.

Treasuries’ Role Grows

“It’s been painful to be underweight Treasuries during a time when you’ve seen an amazing rally,” Daniel Shackelford, part of a group that manages $15 billion in bonds at T. Rowe Price Group Inc. in Baltimore, said in a Sept. 27 telephone interview.

“It’s hard to look at a 10-year note below 2 percent, which is basically where the Fed is targeting inflation, and say that that’s a value over a long period of time,” said Shackelford, whose allocation to Treasuries “hasn’t changed materially” from 18 percent as June 30. “We’ll be in this low-growth, stale environment for a while, but I think that favors corporate balance sheets and mortgages more than it does Treasuries,” he said.

The role of Treasuries in the Barclays index has grown during the financial crisis, increasing by 50 percent from 22 percent of the index at the end of 2007, while corporate bonds have dipped to 19 percent from 20 percent and mortgage securities have declined to 32 percent from 39 percent, Barclays data show.

Yields Plunge

“The majority of fixed-income growth since Lehman collapsed has been in Treasuries, so in many respects Treasuries have been the only game in town,” Bret Barker, a money manager at Los Angeles-based TCW Group Inc., which oversees about $120 billion in assets, said in a Sept. 28 telephone interview. Lehman Brothers Holdings Inc. went bankrupt in September 2008.

“We don’t see much value in Treasuries around these levels, but” investors without the debt face the risk of missing a rally, Barker said. The firm has about 20 percent of its bond assets in Treasuries, he said.

The 10-year Treasury yield began its plunge from 2.95 percent on July 28, after a Commerce Department report showed that the economy almost stalled in the first six months of 2011, prompting economists to lower their forecasts for growth. Yields were pulled lower again as investors sought the safety of Treasuries after S&P lowered the U.S. rating to AA+ from AAA.

Rating Cut, Affirmed

In cutting the U.S. one step, S&P acknowledged that it had made a $2 trillion accounting error and then cited the weakening “effectiveness, stability and predictability of American policymaking and political institutions.” The company, a unit of New York-based McGraw Hill Cos., since announced that Deven Sharma will step down at the end of the year and will be replaced by Douglas Peterson as president.

A Bloomberg survey of 1,031 subscribers found that 57 percent of U.S. investors agreed with S&P’s decision, compared with about 75 percent of those in Europe and Asia. The quarterly review showed that 72 percent of U.S. investors found the nation’s creditworthiness good or excellent, while 45 percent of Europeans agreed and 42 percent of Asians.

While most of those polled backed S&P’s downgrade, 35 percent of investors said that overall the grades given by rating firms aren’t reliable. Only 1 percent called them very reliable, 18 percent fairly reliable and 45 percent just somewhat reliable.

Budget Deficit

The U.S. budget deficit through Aug. 31 was $1.2 trillion, a month before the end of the fiscal year. The deficit for fiscal 2010 was $1.3 trillion after a record $1.4 trillion in 2009. Moody’s Investors Service and Fitch Ratings affirmed their top rankings on Aug. 2, after President Barack Obama and Congress avoided default by agreeing to lift a limit on borrowing. Investors have bid a record $3 for every dollar of debt sold at the $1.6 trillion in Treasury auctions this year.

The average 10-year yield forecast for 2011 among primary dealers, who underwrite the U.S. debt and serve as counterparties to the Fed in its open-market operations, was 3.65 percent at the start of the year, with a low projection of 2.2 percent by HSBC Holdings Plc.

Demand from funds is likely to help keep yields near record lows, said Eric Pellicciaro, head of global rates investment at New York-based BlackRock Inc., which manages $1.14 trillion in fixed-income assets.

Fed Purchases

“Treasuries are still an underinvested asset class,” mostly because the “Fed has hoarded” the securities, Pellicciaro said in a Sept. 28 telephone interview.

Government securities made up 27 percent of the $3.4 billion BlackRock Core Bond Fund portfolio as of Aug. 31, up from 20 percent as of July 31.

The Fed’s decision to purchase $600 billion of Treasuries through last June prompted money managers to sell them to buy riskier assets such as stocks, “exactly as the Fed wanted to see happen,” Pellicciaro said. “There hasn’t been enough time between these Fed operations for supply to build up enough for money managers” to boost their Treasury holdings, he said.

The central bank is the largest holder of Treasuries with $1.7 trillion of them on its balance sheet. The Treasury sold $2.2 trillion of notes and bonds in 2010.

Yields on shorter-maturity Treasuries fell to record lows after the Fed said Aug. 9 that it would hold its overnight lending rate between zero and 0.25 percent through 2013. The 10-year note yield reached 1.6714 percent on Sept. 23 after the central bank announced it would buy $400 billion of bonds with maturities of six to 30 years through June, while selling an equal amount of debt maturing in three years or less.

Unemployment Rate

With most forecasters suggesting the economic recovery would gather momentum this year, investors looked to corporate securities and other riskier assets rather than Treasuries. The median prediction of 71 economists in a Bloomberg News survey published Jan. 13 was for 3.1 percent growth in 2011. The median for 10-year yield in March 2012 was 4 percent, according to a separate Bloomberg survey.

Policy makers in the U.S. face an unemployment rate that has been at 8.8 percent or higher since April 2009, while European finance officials have grappled with mounting sovereign debt problems now affecting Greece, Portugal, Ireland, Spain and Italy since early 2010.

IMF Forecast

The International Monetary Fund on Sept. 20 cut its euro-region growth forecast for this year and next to 1.6 percent and 1.1 percent, respectively. The Washington-based IMF had previously forecast the economy to expand 2 percent this year and 1.7 percent in 2012. The European Central Bank forecasts 2012 growth of about 1.3 percent.

The worsening global economic outlook caught many investors with too few bonds.

“Being so negative on Treasuries has been a very painful trade,” Mark MacQueen, who oversees bond portfolios at Austin, Texas-based Sage Advisory Services Ltd., which manages $9.5 billion, said in a Sept. 27 telephone interview. “In uncertain times like these that is exactly the opposite trade to have on, and a lot of people were hurt.”

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