Noticeably Different

Print article    Email    Share Subscribe   
FINANCIAL LIFE | FALL 2011 EFFECT

Are U.S. Treasuries Still a Risk-Free Asset?

A bond bear market is coming—at least that’s what Bill Gross, the portfolio manager for the largest bond fund in the world (PIMCO Total Return), recently predicted. In fact, absolute bond yields on U.S. Treasuries have steadily declined over the past 30 years, beginning in the early 1980s when then-Fed Chairman Paul Volcker began aggressively fighting inflation. The 10-year Treasury declined from 16 percent in 1982 to under 2.50 percent last year. This long-term trend in favor of bonds (bond prices have an inverse relationship with yields, so that when yields fall, prices rise) will eventually end as the Federal Reserve cannot lower its federal funds rate below the currently mandated .25 percent range. So many investors are now wondering if U.S. Treasury notes and bonds still have a place in a diversified portfolio as a form of insurance.

Bonds-index-penBonds as insurance?

The Federal Reserve’s policies and programs since the Great Recession of 2008–2009 have artificially kept interest rates lower than the free-market would dictate. This reduces a bondholder’s return through lower interest payments and perhaps negative real interest rates (inflation rate minus interest rate). For retirees and others living on a fixed budget, this reduced income has caused financial hardship, and many investors are reaching for yield through lower quality bonds and longer maturities.

Another consequence of the massive monetary and fiscal policy instituted since 2008 is an increase in government spending, which has raised the budget deficit to the mandated debt ceiling limit. The U.S. government hit its $14.3 trillion borrowing limit on May 16, and Moody’s has warned the government could face a downgrade of its AAA rating if the debt ceiling is not raised and if a feasible plan is not reached to control the burgeoning deficits. S&P, another ratings agency, previously issued a negative outlook in April that warns of a one-in-three chance the AAA rating will be cut on U.S. government securities.

Gross is not the only well-known investor to recently make public comments on the precarious state of interest rates and bond markets. Roy Dalio, founder and Chief Investment Officer of Bridgewater Associates, revealed in an interview with Barron’s back in March that he pulled his clients from the bond market in August 2010 and is slightly shorting the bond market. As of May 31, Gross’ PIMCO Total Return fund held a -3 percent short position in U.S. Treasuries and related derivatives.

Stagflation and credit default swaps

A major problem with the outlook suggested by Gross and Dalio is that the United States may be entering a long period of Japanese-like stagflation. The Japanese economy experienced a massive real estate boom in the 1980s that was inevitably followed by a bust. Japanese banks and companies are still trying to recover from the over-investment in a period of little-to-no growth and inflation. The Japanese stock market, Nikkei 225, is down 75 percent from its top more than 20 years ago. We experienced a lost-decade of investing in the United States from 2000–2009, but imagine losing two decades.

In an investing environment with low growth, moderate inflation, and low business and consumer confidence (sound familiar?), return of principal becomes paramount to return on principal. Investing in a U.S. Treasuries will provide that return of principal, but perhaps with lower purchasing power.

Another indication of the rising risk in U.S. Treasuries is the amount of outstanding credit default swaps (CDS) insuring U.S. debt through investment banks. Credit default swaps provide a payoff to the buyer of the CDS in the event of a default. The amount of CDSs has doubled from a year-ago, up to $4 billion, according to the Depository Trust and Clearing Corp.

Recent history lessons

No one knows how the United States’ continued recovery will play out. That is why we diversify to manage risk. One tool for managing risk is to purchase U.S. Treasuries. Are they risk-free? No. The treasury can print money to finance future debts, thereby decreasing the value of the U.S. dollar. In the past year alone, the dollar has declined more than 7 percent against a basket of major foreign currencies, but it still composes well over half of global foreign exchange reserves.

But let’s not forget the lessons of the past. There will come a time when U.S. Treasuries are sought-after as a safe haven just as they were during the financial crises of 2008–2009. The only places to hide in the 2008–2009 downturn were gold, cash (U.S. dollar, Swiss franc), and U.S. Treasuries. The debt concerns in the peripheral countries of Europe are a major risk we continue to monitor. Will the sovereign debt crises be “contained,” unlike the subprime crises? Recall in the summer of 2007 that Ben Bernanke, Chairman of the Federal Reserve, stated that the subprime crises would be contained. In a volatile global economy, it pays to have a small allocation to these non-correlating assets that will maintain value when risk assets are no longer in favor in the next crisis.

 

Derek HicksDerek Hicks is a wealth advisor with LarsonAllen Financial, LLC.
dhicks@larsonallen.com or 612-376-4565

 

One should not rely on this information for the primary basis of investment, tax or financial planning. General market information does not take into account such factors as an individual’s goals, objectives, risk tolerance, tax situation, age, or time frame. We believe the information obtained from third-party sources to be reliable, but neither LarsonAllen Financial, LLC nor its affiliates guarantee its accuracy, timeliness, or completeness. The views, opinions, and estimates herein are subject to change without notice at any time in reaction to shifting market conditions. Tax laws change and investments in the stock market entail risk and potential loss of principal. This material may not be republished in any format without prior consent.


/WorkArea/linkit.aspx?LinkIdentifier=ID&ItemID=10431



Search EFFECT Magazine
Search LarsonAllen
  1. May 2012 Market and Economic Outlook
  2. First Quarter 2012 Market and Economic Outlook
  3. February 2012 Market and Economic Outlook

DisclaimerWeb site terms of usePrivacy policy - Copyright policy

©2012 LarsonAllen LLP Equal Opportunity/Affirmative Action Employer
This site is best viewed with 7.0+ browsers at a resolution of 1024 x 768