Revenge of the Bond Nerds

By RANDALL W. FORSYTH

Treasuries suddenly are popular at new-low yields. Return of capital trumps return on capital.

GROUCHO MARX FAMOUSLY SAID he wouldn't want to be a member of any club that would have him. Based on that principle, when the crowd starts saying positive things about Treasuries, I get worried.

I should first confess that I've been working from home for the better part of the past couple of weeks, which has meant I've been watching more financial television than usual. That, I suspect, may be warping my perceptions.

In any case, I was taken aback by some comments on the tube about the attractiveness of U.S. Treasury securities after the yield on the benchmark 10-year note fell below 3%. Understand that Treasuries had been the object of universal derision among the investment cogniscenti, sort of the equivalent of minivans among auto enthusiasts.

Yet somehow these minivans have been lapping the hottest sports cars. In round terms, the iShares Barclays 20+ Year Treasury Bond exchange-traded fund (TLT), is up more than 10% since April while the PowerShares QQQ ETF (QQQQ) that tracks the Nasdaq 100 is down more than 10%. Call it revenge of the nerds.

This hasn't been a short-term phenomenon. As Robert Kessler, head of the eponymously named Kessler Investment Advisors of Denver, points out, "perpetually maligned" 10-year Treasury zero-coupon STRIPS have outperformed both stocks (using the Standard & Poor's 500) and commodities (as measured by the GSCI total return index) over the past three, five, 10, 15 and 20 years.

Bull markets in bonds, Kessler continues, last as long as 37 years. Yields peaked some 28 years ago in 1982, so they can continue to decline. Even at this relatively advanced stage of the Treasury bull market, he also points out that U.S. households' allocations to Treasuries is just 1.7%, compared to 4.6% in 1994 and 8.1% in 1952. That doesn't take into account proxies such as ETFs such as TLT, but the underweighting of Treasuries makes suggestion of a bubble less than credible.

Most active investors have missed the rally that has brought the yield on the Treasury 30-year long bond down from 5% before Easter to under 4% ahead of the July 4th holiday. What's even less well understood is the implications of the bond math of that advance. It's a bigger percentage move than what's remembered as the greatest bond rally in history, when yields fell from 14% to under 10% in the early 1980s. In price terms, the recent gain has been over 20% on long-term STRIPS -- during a period that deep thinkers about concepts such as black swans asserted that everybody should short Treasuries.

But now that the two-year note yield dropped to a record low under 0.6% -- even below the crisis lows following Lehman's collapse in late 2008 -- or the three-year note is under 1% or the five-year note is under 2%, the wisdom of owning Treasuries is being appreciated even by talking heads on cable TV.

Which is what makes me uncomfortable. Intel (INTC) yields 3.10%, more than the 10-year Treasury and is arguably the most important tech company in the world. If there were no Apple, life would go on without its lovely gadgets. Without Intel microprocessors, personal computers -- including Macs -- couldn't function.

Microsoft (MSFT) yields more than the five-year Treasury at 2.1o%. And most of Corporate America uses Windows and Office, the programs that produce massive free cash flow to Microsoft investors.

So, the question is why own Treasuries when Blue Chips such as Intel and Microsoft yield more? Simply because those stocks lost 3% and 4%, respectively, in Tuesday's rout. Other Dow stocks such as ExxonMobil (MOB) and Altria (MO) also lost 2% even though they handily outyield Treasuries.

Market psychology is being dominated by another dictum of one of Groucho's contemporaries, Will Rogers. The homespun philosopher said in the 1930s that return of capital was more important than return on capital.

This is more than a quarter-end phenomenon, although the calendar clearly is exaggerating the market's swings. The decline in all risk assets, notably commodities along with equities, points to economic weakness and, perhaps, outright contraction. That would suggest lower stock prices and Treasury yields in the near term.

Over the next 10 years, I would rather own stocks of great American multinational companies that create wealth rather than the debt of the U.S. government, which absorbs wealth. Over the next 10 months, I'm not so sure. And on that score, I'm afraid I have too much company. Even so, I'd rather protect principal for now in order to have the cash to buy these great companies later at bargain prices.


From online Barrons published on WEDNESDAY, JUNE 30, 2010

Bonds Gain in Best Year Since ‘05 as Rally May End

June 28, 2010, 6:14 AM EDT (Updated today’s 10-year yield in sixth paragraph.) By Mary Childs June 28 (Bloomberg) -- Global bond returns may have nowhere to go but down after the best first half since 2005. Investors who piled into Treasuries, bunds, gilts, and Japanese bonds on concern that Europe’s sovereign-debt crisis would derail global growth are finding the securities less appealing with yields at about the lowest on record. The emerging bearishness may be most apparent in the $4.3 trillion- a-day market for U.S. Treasury repurchase agreements, where no maturity commands a premium. That’s a switch from a year earlier, when investors resorted to paying interest to borrowers while lending cash just to obtain Treasuries after the worst finance crisis since the Great Depression. None of the securities are what traders call on “special” in a sign that investors don’t expect Europe’s sovereign debt crisis will curb the global economic recovery, according to data from GovPX Inc., a unit of ICAP Plc, the world’s largest inter-dealer broker.

“No one’s freaking out,” said Jason Brady, a managing director at Thornburg Investment Management in Santa Fe, New Mexico, which oversees $59 billion. “It’s definitely a much more situation normal indicator than what we saw a couple years ago when it was a horror show. As we’ve gotten to lower yields in Treasuries, they’ve gotten less interesting.” Yield Forecasts Treasury 10-year note yields, the benchmark for everything from mortgages to corporate bonds, will climb to 3.74 percent by year-end from 3.11 percent on June 25, based on a Bloomberg survey of forecasters. That would imply a loss of about 3.26 percent as yields rise and note prices fall, according to data compiled by Bloomberg. The 10-year note yielded 3.09 percent today as of 6:09 a.m. in New York. Government debt is “our least-favored segment of the bond market,” a team of strategists led by Jeff Applegate, who oversees about $1.8 trillion as chief investment officer for Citi Global Wealth Management in New York, said last week in the firm’s Global Investment Committee Monthly report for June. “We expect to see higher yields once investor risk aversion recedes, causing this sector of the bond market to underperform.” Leading the Gains The benchmark 10-year Treasury note has returned 7.85 percent this year, including reinvested interest, leading global government bonds to a gain of 3.36 percent, according to Bank of America Merrill Lynch indexes. That’s the best start since the firm’s broadest sovereign debt index rose 3.77 percent in the first half of 2005. Sovereign debt yields dropped to 2.10 percent on average last week, within 3 basis points of the low of 2.07 percent reached on May 25, based on the firm’s Global Sovereign Broad Market Plus Index. The gauge tracks 1,165 bonds with a market value of $18.6 trillion. Instead, slower inflation, worsening government finances in Europe and concern that Greece will default on its debt and send the global economy into another recession led investors to seek the safety of bonds issued by G-7 nations. The MSCI World Index of stocks has fallen 7.44 percent this year. Rate Outlook Federal Reserve policy makers won’t raise interest rates until the first quarter of next year, based on the median estimate in a Bloomberg survey of economists this month. After leaving its target rate for overnight loans between banks in a record low range of zero to 0.25 percent on June 23, the Fed said in a statement that “financial conditions have become less supportive of economic growth on balance, largely reflecting developments abroad.” It also reiterated that it will keep rates low for an “extended period.” “We need to really get some solid ground under us” before central banks tighten monetary policy, said David Ader, head of government bond strategy at Stamford, Connecticut-based CRT Capital Group LLC. “I don’t think people are willing to make bets right now.” Low yields are helping governments finance their budgets deficits more cheaply. The administration of President Barack Obama spent $248.2 billion in interest expense in the first eight months of fiscal 2010 ending Sept. 30, up 16 percent from $214 billion in the same period of 2009 even though the amount of market debt outstanding rose 23 percent to $7.96 trillion, Treasury figures show. German Growth While reports last week showed housing sales in the U.S. fell, other data indicate concern the economy will slow may be overblown. The Thomson Reuters/University of Michigan index of consumer sentiment increased to 76 for June, from 73.6 in May. Germany’s Ifo institute in Munich said last week its business climate index, based on a survey of 7,000 executives, increased to 101.8 from 101.5 in May. That’s the highest since May 2008. Economists expected a decline to 101.2, according to the median of 38 forecasts in a Bloomberg survey. Japan’s Cabinet Office said June 10 the nation’s gross domestic product rose at an annualized 5 percent rate in the three months ended March 31, the biggest gain since the second quarter of 2009. The median of 18 estimates in a Bloomberg survey of economists was for a 4.2 percent pace. Diminishing Demand Such data help explain why demand for Treasuries has diminished in the repurchase agreement market. That’s a switch from recent years when the debt was in such high demand as credit markets froze that investors routinely lent cash for next to nothing just to obtain the securities through so-called repos, which securities firms use to finance their holdings. “There are very few specials out in the market and that’s been the case for quite a while now,” said Thomas Simons, a money-market economist in New York at Jefferies & Co., one of the 18 primary dealers that trade with the Fed. “Around month- end, quarter-end, and definitely year-end, they tend to heat up in the last few days but it’s not like it used to be.” The overnight repo rate on the current two-year Treasury, the 0.625 percent coupon security, closed the same as the general-collateral rate of 0.25 percent on June 25, according to GovPX. A year earlier, the overnight rate was negative 0.05 percent, while the general-collateral rate was 0.05 percent. German Bunds German bonds gained 6.69 percent this year, poised for the best first-half performance since 1995, according to Bank of America Merrill Lynch indexes. The gains pushed the yield on the 10-year bund to 2.5 percent on June 8, the lowest since at least January 1989, according to Bloomberg generic prices. “We could see some calm return to the markets in coming months,” said Michiel de Bruin, who helps manage about $32 billion as head of European government bonds at the Dutch unit of F&C Asset Management in Amsterdam. “I can’t really see Treasury or bund yields falling much from current levels.” Ten-year bund yields are forecast to rise from 2.61 percent from 3.11 percent by the end of the year, according to the median estimate in a Bloomberg survey.

In the U.K., where bonds have returned 5.62 percent since December, 10-year yields will likely rise to 4.05 percent in six months from 3.38 percent last week, a separate poll shows. Japanese Bonds Japan’s government bonds have handed investors a 1.5 percent return this year. Ten-year yields, which touched 1.16 percent on June 23, the lowest since Dec. 30, 2008, will climb to 1.39 percent from 1.15 percent, another survey shows. Not even a pledge by new Japanese Prime Minister Naoto Kan to restrict borrowing and overhaul the tax system will keep yields from rising, according to Shinji Nomura, chief debt strategist in Tokyo at Nikko Cordial Securities Inc., a unit of Japan’s third-largest banking group. “Yields are too low to entice investors any longer,” he said. “The economy continues to recover after hitting bottom.” For many investors, riskier assets are just too attractive to ignore after lagging behind bonds, regardless of what the economy does, according to Richard Schlanger, who helps invest $18 billion in fixed-income securities as vice president at Pioneer Investments in Boston. “I would not want to be a buyer, a long term investor, of 10-year Treasuries at 3.09,” said Schlanger, a money manager at the firm. “It’s just hard to believe we can continue to rally in the Treasury market. Equities and commodities would be better places to put your money.” Schlanger forecasts 10-year Treasury yields may reach 3.5 percent this year as the economy improves. --With assistance from Daniel Kruger in New York, Yoshiaka Nohara in Tokyo and Lukanyo Mnyanda in London. Editors: Dave Liedtka, Nicholas Reynolds To contact the reporter on this story: Mary Childs in New York at mchilds5@bloomberg.net To contact the editor responsible for this story: Dave Liedtka at dliedtka@bloomberg.net From Bloomberg Business Week published on June 28, 2010, 6:14 AM EDT

Choosing the Right Bond Funds

Determine Your Bond Fund Allocation Before you choose bond funds, it is important to decide the role they will play in your portfolio. Your bond fund allocation should reflect your investment time horizon; your specific investment goals, which may include retirement, retirement income, or tax-free income; and your tolerance for risk. chart This chart can help you determine an appropriate allocation for bond funds while recommending allocation levels for investment-grade, high-yield, and international bonds to help you meet the needs of your individual investment time line. Use our tool to see what we suggest for your portfolio Investing in several bond funds with different investment strategies can help cushion the effects of interest rate risk and credit risk on your overall portfolio. For example, investing in both shorter- and longer-term maturities can help your strategy stay on track during both high and low interest rate climates. This also can be achieved by investing in a diversified single-fund option like the Spectrum Income Fund. U.S. Treasury Bond Funds These funds invest in Treasury-bills, Treasury notes, and Treasury bonds issued by the federal government, with varying maturities: * Treasury bills or "T-bills" have maturities of 13 weeks, 26 weeks, or one year * Treasury notes mature in two to 10 years * Treasury bonds mature in 10 years or longer They are high-quality, relatively safe investments with almost no risk of default. Treasury securities are backed by the full faith and credit of the U.S. government. Although the securities in which the funds invest are backed by the U.S. government, the funds themselves are not. Yield and share price will vary. Bond funds of this type are also subject to interest rate risk, the degree of which depends on the maturity. (Longer-term bonds have a higher risk/return potential.) Who should invest? Investors with a low risk tolerance or those who seek to balance a higher-risk portfolio with securities backed by the credit of the government. Tax-Free Bond Funds Municipal bond funds offer income that is exempt from federal taxes. In addition, certain state-specific municipal bond funds can provide income free of state and local taxes to state residents. Tax-free bonds typically offer lower yields than comparable bond funds, but in many cases this is more than offset by tax savings, resulting in higher after-tax income. (Some income may be subject to the federal alternative minimum tax.) Who should invest? Investors in a higher tax bracket or those who live in high-tax states should consider tax-free bond funds. Corporate Bond Funds These funds invest in bonds issued by corporations. The funds' risk/return potential can vary according to term length and credit rating. Some corporate bond funds invest in bonds that are below investment grade and pose higher risk but offer higher return potential than other funds concentrating on investment-grade corporate bonds. Who should invest? Investors who can withstand more price fluctuations with the prospect of higher returns compared with U.S. Treasury funds. Depending on the fund’s risk/return potential, corporate bond funds can be appropriate for any portfolio. Mortgage-Backed Securities Funds These funds invest primarily in certificates, such as those issued by the Government National Mortgage Association (GNMA, or Ginnie Mae), that represent a pool of mortgages. They also may invest in securities issued by other government-sponsored enterprises. Mortgage-backed securities tend to have high credit quality; in fact, GNMA guarantees the timely payment of interest and principal on its securities, a guarantee backed by the U.S. Treasury. However, mortgage-backed securities also carry market, credit, maturity, and prepayment risks. Who should invest? Investors seeking higher income than is provided by Treasury securities of comparable maturity and who can tolerate greater risk should consider mortgage-backed securities funds. International and Global Bond Funds Investors can use international or global bonds to diversify their bond allocation in their overall portfolio. International bond funds invest in bonds issued by countries or corporations outside the U.S., while global funds may also include U.S. issuers. These funds are subject to special risks that are typical of international investing such as currency fluctuations and political and economic changes. Bond investments from emerging markets are particularly volatile. Who should invest? Investors seeking further diversification opportunities and higher potential returns should consider the advantages of global and international bond funds. Blended Bond Funds Investors who do not wish to pick and choose a selection of bond funds can invest in a diverse range of bond funds with one selection, as in the Spectrum Income Fund. Single-fund options may combine short- and long-term bonds, domestic and foreign bonds, and different credit ratings to maximize potential earnings while addressing risk. Who should invest? Investors who want convenience and broad exposure across the spectrum of bond fund options should consider a single-fund solution. From T.Rowe Price