Bond Risk Highest Since Eisenhower as U.S. Pushes Long Debt
The risk of owning U.S. government debt is as great as any time since the 1950s with yields at the year’s lows and Treasury Secretary Timothy F. Geithner locking in borrowing costs by selling longer-term securities.
Yields on Treasuries would only need to rise 0.3 percentage point over one year on average from 1.67 percent to produce a loss, based on the benchmark Barclays Treasury index, a study by Los Angeles-based First Pacific Advisors shows. The last time bonds were close to this level was in March 2009, when a 0.43 percentage point rise in yields would have left holders of comparable maturity five-year Treasuries with losses.
“You have to go back into the 1950s to find this kind of activity,” said Thomas Atteberry, who manages $3.7 billion in fixed income assets at First Pacific in Los Angeles. “Interest- rate risk is the most acute it’s been in an extremely long time. I have to stay short, five years and in.”
By shifting more of the risk of higher interest rates onto investors as it increases the average maturity of U.S. debt, the Treasury risks damping demand at bond auctions needed to finance the government’s $1.3 trillion budget deficit. The average due date of the $9.1 trillion of marketable debt outstanding rose to 60 months in March from a 24-year low of 49 months in 2008.
“For new money that comes in today, there isn’t much of a cushion,” said James Sarni, senior managing partner at Los Angeles-based Payden & Rygel, which manages $50 billion. “The risk of losing money is, I believe, quite substantial.”
Bonds rallied last week as reports showed manufacturing in May expanded at the slowest pace in 20 months, unemployment rose to 9.1 percent and consumer confidence fell to a six-month low.
The yield on the benchmark five-year note was little changed at 1.59 percent at 7 a.m. in New York after falling 12 basis points, or 0.12 percentage point, last week. The price of the 1.75 percent security due in May 2016 rose 18/32 in the five days to June 3, or $5.63 per $1,000 face amount, to 100 23/32, Bloomberg Bond Trader prices show. Ten-year yields dropped 9 basis points to 2.99 percent last week after reaching 2.94 percent on June 1, the lowest since Dec. 6.
The median estimate of 70 economists and strategist surveyed by Bloomberg News is for the 10-year yield to rise to 3.8 percent by year-end. Investors in the security would lose 4.63 percent, Bloomberg data show, because prices of bonds with longer maturities are typically more vulnerable to movements in interest rates since their payments extend over a greater period.
Holders of two-year notes would lose about 1.02 percent if the yield climbs to the median estimate of 1.33 percent from 0.42 percent on June 3. The price of the notes would fall about $13 per $1,000 to 98 27/32 from 100 5/32, exceeding the $5 in annual interest on the security.
Allstate Corp., which manages $80.2 billion in fixed-income assets, and Loews Corp.’s CNA Financial Corp. unit, which oversees $38 billion of bonds, said they are shifting to intermediate maturities given the risk to the principal of longer-term securities.
“What we’re focused on is maintaining yields in the portfolio and optimizing interest-rate risk,” Judy Greffin, Northbrook, Illinois-based Allstate’s chief investment officer, said on a June 1 conference call with analysts.
Medium-term bonds are “basically the sweet spot for us,” James Tisch, chief executive officer of Loews, said June 3 at a conference in New York. “It provides us protection in case interest rates continue to decline, but likewise if interest rates rise it provides us a steady cash flow of both cash and maturing investments so we can then reinvest at the higher rates.”
Of the $2.249 trillion of notes and bonds sold by the Treasury in 2010, 38 percent or $851 billion were of maturities of more than five years, compared with 25 percent or $231 billion of the $922 billion sold in 2008. Demand has increased as sales continue at a near-record pace. The Treasury has received $3 in bids for every dollar auctioned this year, compared with last year’s record $2.99, government data show. The U.S. has sold $895 billion of notes and bonds in 2011, versus $1.003 trillion at this time in 2010.
Yields on 10-year notes are 2.2 percentage points below the average over the past 20 years and about half the average since 1953, when President Dwight Eisenhower began his administration.
The yield remained below 3 percent from the third quarter of 1953 through the second quarter of 1956, and dipped below that level again in 1958 as Eisenhower grappled with an economy that fell into a 10-month recession in 1953, an eight-month contraction in 1957 and another 10-month slowdown in 1960.
Bond yields began a 20-year climb after the end of the last Eisenhower recession in 1961, reaching a peak at 15.8 percent in 1981 as Fed Chairman Paul Volcker raised the central bank’s target rate for overnight loans between banks to 20 percent to contain surging inflation.
While the risk of holding bonds may be the same as the 1950s, new financial products derived from Treasuries may raise the danger level, according to David Jones, 72, former vice chairman of Aubrey G. Lanston & Co. The firm was one of the original primary dealers that are obligated to bid at Treasury auctions.
“We now have a Treasury bond market that is global and we have so many different categories of debt and derivatives that you can almost make no comparison,” Jones said. “It lends a lot of volatility to the Treasury yield we never had before when it was a much more domestically focused market.”
This year’s rally led James Kochan, who helps manage $231 billion as chief fixed-income strategist at Wells Fargo Fund Management LLC in Menomonee Falls, Wisconsin, to stop advocating the purchase of long-term U.S. government debt. Yields on Treasuries due in 10 years or sooner are all less than the 3.2 percent increase in the consumer price index in the 12 months ended April 30.
“You’ve got a lot more risk in this market now,” Kochan said. “If I had to own Treasuries here I’d be coming in on the curve,” buying shorter-term notes, he said. “This rally’s overdone.”
Yields have declined as government and private measures of economic growth have fallen below economist forecasts, boosting speculation inflation may slow and make bonds more valuable.
The Institute for Supply Management said June 1 that its factory index plunged to 53.5 in May from 60.4 the prior month. A day earlier, the Conference Board’s confidence index dropped to 60.8 from a revised 66 reading in April.
Employers added a fewer-than-projected 54,000 jobs last month, the Labor Department said June 3. The median forecast in a Bloomberg News survey called for payrolls to rise by 165,000.
Economists at Barclays Capital Inc. cut their forecast for second-quarter economic growth on June 3 to a 2 percent annual rate from a prior estimate of 3.5 percent. They lowered their projection for the third quarter to 3 percent from 3.5 percent.
Even with the economy slow, the potential for losses on Treasuries is too great to make the securities attractive after yields fell to the lowest this year, according to David Brownlee, head of fixed income at Sentinel Asset Management in Montpelier, Vermont, which manages $28 billion.
“We’ve been liquidating Treasuries,” Brownlee said. “It’s not that we hate them as an asset class, but we’ve been looking at more short-term mortgage backed securities.”
‘Close to a Floor’
Treasuries have returned 2.85 percent on average this year, including reinvested interest, according to bank of America Merrill Lynch index data. Mortgage securities returned 3 percent on average.
The rally is dependent on the economy falling back into recession, said Krishna Memani, director of fixed income at OppenheimerFunds Inc. in New York, who helps manage $70 billion.
If the market gets improving data in the U.S. and signs of stabilization in Japan and Europe “I can see rates rising 50 to 60 basis points fairly quickly,” Memani said. “We are getting quite close to a floor in Treasury yields.”
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