Time to Sell Treasury Bonds?

Treasury bonds have recently endured a vicious correction, with yields on 10-year Treasuries rising from an all-time low of 2.04% on December 18th to 3.94% yesterday (June 10th). Using an Exchange Traded Fund that invests in a portfolio of 7-10 year Treasury bonds (symbol: IEF) as a proxy, the total return loss in Treasury bonds during that time has been -10.3%. That’s not exactly the kind of return investors usually expect from a perceived “safe” investment like Treasury bonds.

What’s been behind the recent rout in Treasuries? For one thing, risk appetites have slowly been returning to normal as the economy seems to have passed the worst of the downdraft, allowing investors to gradually move out of Treasury securities and into higher yielding debt and stocks. In addition, it seems that bond investors have a few concerns these days that are causing them to demand a higher yield, including massive new issuance as the government borrows trillions of dollars to pay for all of the bailout efforts; fears of foreign countries with large Treasury holdings selling them to diversify into other securities; expectations of stronger economic growth in coming months; and inflation worries as oil and other commodities have rebounded of late.

So, should investors immediately sell all of their Treasury holdings? Is a return to the double-digit interest rates of the late 1970s & early 1980s right around the corner? We don’t think so. The size and scope of the financial collapse has created a tremendous amount of idle capacity in the global economy, and so we don’t think that inflation is an immediate threat. And, there’s still a lot of uncertainty about the economic outlook, despite some positive developments lately, meaning that any setback could cause another stampede back into the safety of Treasury bonds. We think there’s a better chance that bonds will trade in a wide range, similar to what we believe may be in store for the stock market, with large moves in both directions as the economy works through a bottoming process. In short, we’re still confident that Treasuries play an important role in a diversified portfolio – for now, anyway.

Municipals and Treasuries

Last year, 2008, municipal bonds had a rough year relative to U.S. Treasury bonds. With the flight to quality during the credit crunch of 2008, 10-Year Treasury bonds gained 14% more than their muncipal counterparts, on average. This performance difference was best reflected in the comparison between AAA municipal yields and U.S. Treasury yields. In late 2008, AAA municipal yields were a staggering 130% of Treasury yields on many parts of the yield curve. As an example, a 10-year Treasury yielded 2.25% and a 10-year municipal yielded 3%, and the after tax benefit was even greater especially if the municipal bond was your own state’s issue.

However, as the credit crunch has eased and the flight to U.S. Treasuries has been halted, we’ve seen a much different picture so far this year. The chart below compares the year to date performance of the 7-10 Year Treasury ETF (IEF) with the intermediate National Municipal Bond ETF (MUB). Treasury investors have a lot on their mind with supply concerns, inflationary pressures that could build in a few years, and now, dare I say, potential downgrade concerns. And while municipal investors may have their own default concerns as states battle budgetary problems, investors have clearly felt more comfortable in that space recently since munis have handily outperformed Treasuries this year.

It is generally assumed that investors will own Treasury bonds in tax deferred accounts and muncipal bonds in taxable accounts, in order to maximize after-tax returns. But the last year and a half has really shined a light upon total return investing in bonds. The huge return differentials over multi-month periods argue for a more actively managed approach to managing bond portfolios, which is our strategy here at Pinnacle.

Breaking 3%

On March 18, 2009 the Federal Reserve announced plans to purchase $300 billion of long-term government bonds in an effort to lower rates on mortgages and other debt instruments. The ten year Treasury was trading at 3.01%, which seemed to mark the point of defense for the Fed. Yields on the ten year quickly fell to 2.5% after the big announcement (as marked by the red arrow in the chart below), and Fannie Mae mortgage commitment rates dropped to 4.25%.

But on Wednesday, following the Fed’s latest meeting, there was no announcement on future purchases – and the Treasury market did not like that news. Yields broke above the key 3% level and now stand at 3.12% and are rising. Are supply issues due to future funding of the fiscal deficit weighing on investors’ minds? Are deflationary forces subsiding, reinforced by a strong reading of the GDP Price Index? I feel there are many different contributing factors to this rise, but one thing seems certain – the Fed will have to really ramp up their efforts if they wish to keep interest rates from rising any higher.