The Treasury Bond Bubble: A Survival Guide for Investors

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U.S. Treasury Dept.Concerns have been escalating lately about the possible risks of investing in Treasury bonds. Just how bad is that risk, and what should investors do about it?

The most ominous warning came from Tobias M. Levkovich, U.S. equity strategist at Citigroup. In a note to clients on Monday, Levovich said he had found a "startling" correlation between equity returns in the period from 1990 to 2005 and Treasury bonds since 2000.

"It would suggest that the tremendous money flows into bond funds could end with similar losses to that which transpired for equity investors who poured cash excessively into stock funds back in 2000," Levkovich wrote. He was referring, of course, to the dot-com crash, when the Nasdaq index declined 46% from September 2000 to January 2001.

Rates Can Only Go Up From Here

Writing in The Wall Street Journal on Tuesday, Jeremy Siegel, a finance professor at the University of Pennsylvania, and Jeremy Schwartz, director of research at WisdomTree, a sponsor of exchange-traded funds, warned that investors in bond funds are "courting disaster," and made the same comparison to the 2000 tech-stock bubble.

Siegel and Schwartz said that if 10-year Treasury bond rates, now at 2.8%, rise to 4%, the capital loss on bonds will be more than three times the current yield. They said there was no doubt that interest rates would rise as government programs to care for the baby boomer generation kick into gear.

So what's an investor with a bond portfolio heavily invested in Treasurys, which have the cachet of being the world's safest investment, supposed to do now? Some investment advisers recommend coming up with a long-term iplan and sticking to it despite the marketplace's short-term ups and downs.

Consider Good-Quality Corporate Bonds

But even with a long-term strategy in place, investors can tweak their portfolio to avoid a potential disaster.

Marilyn Cohen is a fund manager at Envision Capital Management, a Los Angles fixed-income investment management company, and the author of Bonds Now!, a bestselling guide to bond investing. She urges investors with large investments in Treasury bond funds to "take some or all of your gains off the table."

Instead of government debt, she says, investors should buy individual bonds, mainly corporate bonds rated BBB+ and above, which she says have a decent "spread," or a positive interest rate difference, over Treasury bonds.

By buying individual bonds, she says, investors can lock in maturity and yield, and can avoid the problem in some bond funds of a declining dividend caused by investors stampeding into the funds, forcing the fund managers to buy lower-yielding securities.

"I would stay out of the Treasury market because the yields are too painfully low, and I would be very selective in buying good-quality corporate bonds, which are in an unbelievable sweet spot," Cohen says.

Shorten Your "Duration Risk"

Admitting it's a bit of "blasphemy for a bond fund manager," Cohen also likes high-yielding stocks like Altria (MO) and Bristol Meyers Squibb (BMY). "If you compare some of these high-dividend-yielding stocks, to the 10-year Treasury bond, the stocks beat them by a mile," she says. They also tend to go down less in a downturn than other equities, she says.

Another investment approach is outlined by William J. Bernstein, author of The Investor's Manifesto: Preparing for Prosperity, Armageddon, and Everything In Between.

Bernstein, a medical doctor who studies economic history as a hobby, agrees with Cohen that investors should exit Treasury bond funds as soon as possible and hold individual bonds. But he says investing in corporate bonds is a mistake because even with the highest-rated corporates, over the long haul the return isn't much more than 0.5% above Treasurys of similar duration. "That extra return is just not worth the risk," Bernstein says.

While Bernstein recommends sticking with government securities, he suggests that investors who are invested in Treasury or corporate bond funds shorten their "duration risk." "If your fund has an average duration of more than three years, I would exchange that for a fund that has a shorter duration," he says.

He notes that if you own a one-year Treasury and interest rates suddenly spike upward, you can roll over the bond within a relatively short period of time. While interest rates in short-term Treasuries are near zero, "if you do get a dramatic rise in rates and fall in prices, that zero return is going to look pretty good." That's because when interest rates go up, the value of existing bonds goes down, and they're worth less when sold on the secondary market.

What should investors who own Treasurys for income do now that rates are so low? Says Bernstein: "That person is going to have to suck it up. Chasing yield is one of the most dangerous things you can do."

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lil0102

well, whm in their right mind trusted state and city union employees, worthless is best case scenerio, when are you fools will learn, gold in your hand is much better than any IOU treasury, bond, stock.

August 20 2010 at 9:16 PM Report abuse rate up rate down Reply
sanfopar

I always have to laugh when I hear the stupidity that comes out of the mouths of these so called experts ,,It seems to me that they all forgot the basic economics of demand and supply ,,,Even though the FED can raise and lower rates with monetary policy ,,The market will enventually dictate the interest rate levels ,,It really is not any different from a retailer setting and price ,,and then discovering he must raise or lower the price ,to meet the market demand ,,If you examine the market ,you will realize there is little reason to raise rates ,and you can make an argument that lowering rates are the way to go despite the fact that rates are so low ,now ,, You can also make a good argument to keep rate steady ,,at this point ,BUT ,If you were to raise rates ,at this point in the so called recovery ,,you might aggravate the double dip ,,Frankly I think we are in a double dip right now ,so the rates may have to be adjusted even lower ,,Keep in mind just because the price is low ( and keep in mind ,interest rates are the price of the cost of money for borrowing purposes ,,) ,,,does not mean that rates can even go lower ,,I know that many of these same experts were telling the pubic the same thing 2 years ago ,(that rates were going up )_ ,They were wrong then and they are wrong now

August 20 2010 at 5:56 PM Report abuse +1 rate up rate down Reply
zweifler

A lot has happened to the Wharton School since I went there in the 1950s - We had a finance department headed by Julius Grodinsky (sp ?) who taught us about growth price earnings ratios and prepared us for the post war boom-bust-boom-bust. By contrast, Professor Jeremy Siegel who took Julius's place has predicted an uninterrupted boom-boom - predicting that the Dow Jones Industrial Average would reach what we can kindly define as "unrealistic" levels. Now he predicts a treasury bond bubble. Permit me to disagree with my Wharton Bachelor of Economics degree vs his PhD. Higher rates are predicated on inflationary expectations and a return to the good old days pre-2006. Its not in the cards! The deleveraging of the U.S. consumer is taking place. - If there is exposure it is in equities - not bonds. Dr. Siegel - - remember when we pegged the short term rate at 7/8% and the long term rate at 2.5% under Roosevelt and Truman? We are far from the rate bottom! - If you are looking for a bubble - look to the Chinese real estate markets and hope that when they flood the market with U.S. Treasuries that the Federal Reserve Bank will fulfill its promise to buy - i.e. quantitative easing. With China, the second largest economy in the world in a bubble of its own where can a nice gal or guy investor go but into the safety of fixed income securities. Its a contrarian paradise and we want to talk to others who share our enthusiasm for the investment opportunity before us - in Treasuries and high grade long maturities.

August 20 2010 at 5:42 PM Report abuse rate up rate down Reply
bzh484

I just finished reading an article which states that Wall Street is against Bonds. So, why should we listen to Citigroup and fund managers. Let us go back to basics. The government has not said we are out of the recession. Those are the words instead of calling it a double dip. The bigger question is are we headed to a depression. Now most analyst are saying to buy short turn Bond Funds. Now advice to buy the actual bonds. I hope you are all rich enough to buy a bond portfolio. Somewhere around 10 million dollars.

August 20 2010 at 2:32 PM Report abuse rate up rate down Reply
dsnewt97

I own treasuries going out to 2017, yielding upwards of 6%. I've held those for over 10 years now and see no good reason to dump them, even at the premimum they are bringing now. Unless the USGovt. defaults or falls,then who knows what to do? I stil feel good about them so far.

August 20 2010 at 11:21 AM Report abuse +1 rate up rate down Reply
welshwlsh

Buy Gold

August 20 2010 at 11:14 AM Report abuse +1 rate up rate down Reply
2 replies to welshwlsh's comment
ibilliybob

Where to invest? Simple, if you have ANY debt--pay off any obligation that charges you interest. A credit card int. of 12% (good luck) or Treasuries at .12%. Make double payments on your home mortgage. When value returns to financials then invest. Simple.

August 20 2010 at 10:04 AM Report abuse +2 rate up rate down Reply
LEE Resolution

tjdwil 8:04 AM Aug 20, 2010 * (2) vote this comment up * (2) vote this comment down * Looks like we're still mired in the Winless War in Afghanistan,,,,,,,guess that's "W's" fault too ?............When do you believe that the country should expect BO to take responsibility, and stop using Bush as an excuse? ************ When one side engaged in a war has 'rules of engagement' and the other side doesn't, the latter will always win. No different than 'rules of engagement' in terms of the economy but for the fact that lives are at stake.

August 20 2010 at 9:45 AM Report abuse +1 rate up rate down Reply
dondavy28

DON'T BUY ANYTHING RELATED WITH THIS GOVERNMENT WITH OBAMASS OR GM STOCK

August 20 2010 at 9:31 AM Report abuse rate up rate down Reply
1 reply to dondavy28's comment
itacurubi

Providing rational arguments for one's opinion is traditional and -- in your case -- might help one ignore your apparent disregard of English idiom. In short, try to limit yourself to two breakfast Buds ... or is it raining and you have no lawns to mow today?

August 20 2010 at 9:40 AM Report abuse -1 rate up rate down Reply
KKiegiel

People fear that the market is about ready to correct back to new lows because employment is not getting better, top line earnings have peaked, so it seems people like the safety of Treasuries. Rates will remain low for the foreseeable future.

August 20 2010 at 9:28 AM Report abuse +1 rate up rate down Reply