Look Past 2008 Stars for Gains in Bonds
The New York Times
Published: Jan 11, 2009
KNOWLEDGEABLE investors have learned, perhaps from costly experience, that they may well be burned by buying the mutual funds with the best recent records.
This year, it seems even more important than usual not to chase performance. That’s because the hands-down winners of 2008, the funds that invest in Treasury bonds and other government-backed securities, outperformed by so much. Along with bear market funds, that category was among the very few to manage any gains.
The search for refuge from turmoil reached such intensity last month that some money managers bid prices for the shortest-maturity Treasury securities to the point that their return was slightly, if briefly, negative. This meant that these “investors” paid the government to serve as their mattress.
If you hold a Treasury security to maturity, of course, you’ll get back your principal, though maybe not its full purchasing power. But if you have to sell early, you’ll lose value if prevailing yields rise. That’s because bond prices and rates move in opposite directions.
Investors cannot be hurt too badly in short-term securities like Treasury bills, which may mature in a matter of weeks. But Treasury issues with longer maturities have also surged to the highest prices — and therefore the lowest yields — in a generation or more, inviting even the most conservative-minded investors to view the category with suspicion.
(Bond funds investing in long-term government issues soared more than 20 percent last year, according to Morningstar.)
“You’ve got plenty of risk,” observed Brian Edmonds, head of the government bond dealership at Cantor Fitzgerald, the Wall Street fixed-income firm. Indeed, he added, “there are people who say the Treasury bond market is the biggest bubble in the world.”
The most appealing alternatives, specialists say, may be high-quality corporate and municipal bonds and the longer maturities of the Treasury bonds that are indexed to inflation. So-called junk corporates and emerging-market debt remain generally out of favor.
Undoubtedly, some disillusioned stock-market investors who have hunkered down in Treasuries think they can’t lose money because the federal government has virtually no risk of default. They believe that the government can always get what it needs to pay off, if not from taxation or borrowing, then simply by printing it.
But there is always the risk of the market, where the spectrum of interest rates shifts in the same unforgiving way as in other bond sectors and can produce shocking losses for the unwary.
“I’d be very hesitant to get into a Treasury investment of any kind at this point,” said Michael Herbst, a fixed-income analyst at Morningstar. Unless an investor does not care about return and is willing to hold on until maturity, there is a risk of “some pretty serious losses,” he said.
For example, if you buy a 10-year Treasury bond currently yielding a bit over 2 percent, you could lose well over half your money if inflation returned to the double-digit levels of the late 1970s and early ’80s and you had to sell before maturity. In August 1981, the government was forced to pay 14 7/8 percent interest in marketing a 10-year bond.
“Unless you expect an extended period of deflation, Treasuries have to be overvalued here,” said Robert B. MacIntosh, chief economist and bond manager at the Eaton Vance Corporation in Boston. “When people are willing to get absolutely zero” return on Treasury bills, he added, “it’s absurd; it can’t last.”
Longer-term Treasuries have also been bid sky-high. The benchmark 10-year issue ended 2008 yielding nearly a full percentage point less than the average dividend in the Standard & Poor’s 500-stock index, the first inversion of this relationship in a half-century. And, after inflation is considered, many Treasury yields were negative, based on traditional applications of the Consumer Price Index, which itself turned down for October and November. Taxes shrink returns further.
What can cause the prices of Treasuries to reverse course, miring in losses investors who may have just been trying to preserve their principal?
Apart from huge issuance of fresh bonds, the answer seems a Hobson’s choice: inflation, or policy makers seeking to prevent inflation.
The hundreds of billions of dollars that Washington has been pouring into the sagging economy seem likely to eventually revive inflation, which policy makers even desire to a modest degree. But there is no telling how much inflation there will be, or when.
“The ultimate risk is that at some point in the future — pretty far down the road — the Federal Reserve is going to hit the emergency brakes because there are inflation pressures that come from all this stimulus,” said David Glocke, a Vanguard Group manager of various Treasury bond funds.
When the Fed starts to tighten, he said, the effect on bond portfolios will be substantial.
“All it takes is for yields to back up just a small degree and you can wipe out a full year’s worth of earnings, given such a low level of interest rates,” Mr. Glocke warned.
Though the Fed cut rates again last month to spur economic recovery, it accompanied the move with a declaration that it stood ready to buy, among other things, longer-term Treasury bonds. This management of the yield curve — the spectrum of interest rates by maturity — would tend to depress rates further, part of a strategy to force investors to be more venturesome and look toward markets where buyers have been scarce despite juicy returns.
This means almost everything else in the fixed-income market, what the trade calls “spread products,” the corporate and municipal sectors whose bonds are often quoted in terms of their yield advantage over comparable-maturity Treasuries.
“Everything the Fed and the Treasury are doing right now is designed to encourage investors to invest in anything but Treasuries,” Mr. Herbst said.
But so far, with inflation gauges falling, there is little sign that the market is looking past the immediate horizon.
The best evidence of complacency about inflation may be that Treasury inflation-protected securities, or TIPS — whose principal is adjusted regularly, based on changes in the C.P.I. — command an exceptionally small premium over ordinary Treasuries of the same maturity. This premium, the so-called break-even rate, has been less than 1 percent, meaning TIPS are the better bet if the inflation rate exceeds that over, for example, the next 10 years.
Experts advise sticking to longer-term TIPS amid the recent monthly C.P.I. declines. Because the annual inflation rate is now so low, shorter-term TIPS don’t seem as likely to benefit as much, if at all, from enhanced principal.
Mr. MacIntosh says that there is “incredible value” almost everywhere in spread products, even in bond funds investing in low-quality corporates whose default rate may well rise further.
The debt of Fannie Mae and Freddie Mac, which have been bailed out by the government, still offers attractive yields of more than 5 percent, but even better opportunities may lie in high-grade parts of both the corporate and municipal markets, various specialists say.
Both markets were badly bruised last year but now seem to offer compelling value, with corporates, best held in tax-advantaged accounts, yielding more relative to comparable Treasuries than at any time since the 1930s.
In the week ended Jan. 2, International Paper bonds due in 2023 were yielding 11.58 percent. Morgan Stanley bonds due in 2014 were at 10.03 percent, and Anadarko Petroleum bonds due in 2016, 7.96 percent.
As for munis, which traditionally have yielded 85 to 90 percent as much as Treasuries but now yield more than them, there is also the possibility of a sharp price rebound.
Mr. Edmonds, who also likes TIPS, suggests that high-bracket taxpayers consider munis at current prices, a category that could also benefit if the Obama administration proposed tax increases when the economy has recovered enough.
“You ought to be in some kind of spread product to capture the added yield that’s out there,” Mr. Glocke said. “At some point we’re going to bust through this cycle and those asset classes should perform extremely well.”
© The New York Times. All rights reserved. This article originally appeared in The New York Times.
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