Introduction

As 10-year Treasury yields sunk below 2.5% in late August 2010, speculation about a ‘Treasury bubble’ has become more apparent.  Some undoubtedly declare this situation a bubble, similar to that of the past dot-com and housing bubbles, as investors chase the recent strong performance of these bonds.  However, some believe it is rather a conservative, shrewd investment, citing the risk-free nature of Treasuries and the modest return investors are pursuing.  This article will discuss the state of the Treasury bond market and examine the current popularity of Treasuries and why their yields are so low today.

 

Is There Really Such a Thing as a Treasury ‘Bubble’?

A market bubble invariably involves greed, driven by the desire to make significant returns in a relatively short period of time.  Although the dot-com and housing bubbles were driven by greed, today’s bullishness with Treasuries is not.  During the dot-com and housing bubbles, many investors quickly doubled, and even tripled, their investment.  However, it is mathematically impossible to achieve that kind of return by investing in Treasuries, as returns from these vehicles (coupons and principal) are mostly fixed.  In Example 1, a $100 hypothetical investment in a 10-Year Treasury note with a hypothetical 3% yield today will be worth approximately $134 ten years from now, resulting in a hypothetical total return of 34% over those ten years.  Hence, there is no true bond bubble as significant returns are not produced.

Example 1

100 x (1 + 3%)10 = $134

On the other hand, Treasuries may not be a conservative, shrewd investment either.  Although they are the de-facto, risk-free investment in terms of credit risk, Treasuries still remain subject to both market and inflation risk. 

For instance, a 1% move in the interest rate of the 10-Year Treasury note discussed in Example 1 will translate to an 8% fluctuation of the market value as the duration of the bond is a little more than 8 years (see Figure 1).  If the 10-Year Treasury yield shifts to 4%, a level seen in early April 2010, the market value of the bond will tumble by 8%.  If the investor intends to hold the bond to maturity and is indifferent to price fluctuation during that period, the bond will still remain subject to inflation risk.  Although the $100 initial investment will still be worth $134 ten years later, the purchasing power of that money may be severely damaged if there is significant inflation over those ten years.  While there is little inflation today, ten years is a lengthy time period and future inflation rates cannot be predicted.  Additionally, targeted inflation is expected to average between 2% and 3% per year in the future.  Thus, a 3% annual nominal return does not provide enough margin of safety and is certainly not a significant return.

Figure 1

Source:  Bloomberg

 

But Why are Treasuries So Popular and Yields so Low?

Treasury bonds can provide certainty in an unprecedented and uncertain environment.  Investors often capitulate to these uncertainties, selecting Treasuries for peace of mind and stability.  Generally, Treasury yields should only succumb to record lows during times of financial crisis.  10-Year Treasury yields reached their record low of 2% at the end of 2008, during the height of the Great Recession when the financial system was in peril and faced significant deflation.  However, the current state of the economy has improved, growing four consecutive quarters, albeit significantly slowing down more recently.  Thus, today’s low yields do not reflect the economic reality, or even the economic projection, but rather investors’ frustration with the unique, yet vague, financial climate. 

As investors continue to worry about inflation and deflation, a double-dip recession, defaulting municipals, a return of the sovereign debt crisis and a substantial increase in taxes, Treasuries provide certainty and a return of principal plus minimum profit backed by the “full faith and credit” of the U.S. government despite market instability.  Therefore, although the market is faring better, investors continue to purchase Treasury bonds for fear of future economic woes.  Scenarios such as this will continue to thrust Treasury yields lower.

Another factor contributing to low Treasury yields is the existence of various natural Treasury buyers who purchase these investment vehicles regardless of price or yield.  For instance, pension funds and life insurance companies have large amounts of defined benefit liabilities, and Treasuries are one of the few financial instruments that will match these institutions’ obligations.  Foreign central banks act as another type of natural buyer, purchasing Treasuries mostly because of the dollar’s reserve currency status or the pegging mechanism of foreign currencies to the dollar.  Additionally, bond mutual funds and bond ETFs also purchase Treasuries, as these vehicles are a major component of the fixed income market.

Conclusion

The recent near-record low Treasury yields may largely be attributable to investors’ capitulation to today’s unusual and uncertain economic environment.  While investment in Treasuries involves the least amount of uncertainty, their valuation is typically rich when yields are historically low.  However, there remains a vast amount of potentially more lucrative investment opportunities in this low yield environment, with only slightly more risk involved.  Although investing in Treasuries is an easy decision to make in the current environment, an easy decision is not always the best decision.

About FundQuest

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The FundQuest name and logo are registered trademarks of BNP Paribas.  The views expressed solely reflect those of FundQuest and the author of this research and are subject to change based on market and other conditions.  The opinions expressed are not guaranteed and do not constitute investment advice or recommendations.

This material represents the opinions of Frank Wei, CFA, as of October 5, 2010 and is not meant as a recommendation or endorsement of any specific investment product or strategy.  Opinions are subject to change.  An individual investor’s situation can vary; therefore the information presented above should be relied upon only when coordinated with individual advice.  Index performance and hypothetical investment examples are presented for illustrative purposes only and do not represent the performance of any specific investment product or portfolios.  An investment cannot be made directly into an index.  Past performance is not a guarantee of future results.  The S&P 500 Index is an unmanaged index comprised of 500 widely held securities considered to be representative of the stock market in general.  Market data source is Bloomberg

©FundQuest, Inc. 2010

Frank Wei, CFA, is a Senior Analyst and a member of the Investment Committee at FundQuest.  He joined FundQuest in 2001 and supervises separately managed accounts, handling the due diligence and monitoring of investment managers.  Prior to joining FundQuest, Mr. Wei was a Research Analyst at Salomon Smith Barney and an Equity Analyst at ABN AMRO Securities.  He possesses 12 years of industry and investment management experience.  Mr. Wei holds a Bachelor of Science in Economics from East China Normal University and an MBA from the Leonard N. Stern School of Business at New York University and is a Chartered Financial Analyst (CFA) charterholder.

Fortune.com, July 2009

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