OCTOBER 3, 2011.
The Stampede Into Debt Continues
Anxiety About a Host of Global Ills Had Investors Scurrying Toward Safety of U.S. Treasurys; Historic Lows for Yields.
By MATT PHILLIPS
The third quarter saw some of the best trades of the post-Lehman Brothers era go off the rails and reinforced the fact that fixed income has trumped stocks for at least a decade.
Amid sluggish economic data, worries about a European financial collapse and fresh, aggressive steps by the Federal Reserve to prop up the economy, Treasurys maturing in 10 years or more have soared in price, pushing yields to historic lows. Since the end of the second quarter, the "long" component of the Barclays U.S. Treasury index has returned roughly 25%, better than during any three-month period since the fourth quarter of 2008 as the financial crisis took hold.
"I don't think there's anything that you could have bought that would have done better," said Michael Shaoul, chairman of Marketfield Asset Management, on the performance of the 30-year Treasury bond this quarter.
Some of the best investments since the financial crisis ran into trouble during the quarter. Stocks, which had risen roughly 90%, dropped 12% as measured by the Dow Jones Industrial Average. Commodities also suffered. Copper futures fell 26%. And crude-oil futures on the New York Mercantile Exchange fell 17%.
Meanwhile, long-term U.S. debt soared. But buying the "long" bond didn't look like a slam-dunk a few months back. With the economy showing signs of recovery and commodities prices soaring, some observers warned that inflation may just be around the corner. Inflation is the archenemy of long-term bond investors, as rising prices eat into fixed dollar returns over time. And as the debt-ceiling debate flared at the end of July, culminating in Standard & Poor's decision to strip the U.S. of its triple-A rating, the status of U.S. Treasurys as the world safest asset seemed threatened.
Indeed, notable bond-market figures missed much of the move, perhaps most famously Bill Gross of Pacific Investment Management Co., who made a reasoned but badly timed bet against U.S. Treasury bonds earlier this year that caused his colossal Pimco Total Return fund to miss a sweeping rally and underperform peers. Mr. Gross later told The Wall Street Journal the move was "a mistake."
To be sure, it could be risky to pile into Treasurys now. In a Sept. 26 interview, Mr. Shaoul said he had sold a winning position in long-term Treasurys that he had held since the spring.
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Still, it is possible bonds, specifically Treasurys, could rally further. But there is a precedent for a large global economy to see bond yields tumble to levels even lower than in the U.S. Since its real-estate bubble burst in the early 1990s, Japan has battled low growth and deflation that have hamstrung its economy and forced long-term bond yields down.
"The Japanese government bond is 1%," said Kenneth Volpert, head of taxable fixed income at Vanguard Group in Valley Forge, Pa. "You could get something where the 10-year U.S. goes into the mid-1s."
On a longer time frame, bonds have continued to be a good bet, outperforming stocks. The total return of the Standard & Poor's 500-stock index over the past 10 years has been 32%, according Standard & Poor's data. Meanwhile, the Barclays Capital U.S. Aggregate bond index returned roughly 73% over the past 10 years.
Further back in the history of the U.S., there also have been moments of extremely low rates. In the early 1930s, a period of pronounced deflation, low loan demand and economic malaise pushed rates down sharply and kept them there throughout the decade. "All through the late 1930s, a lot of 'flight' capital was coming to the U.S.," said Richard Sylla, a professor of financial history at New York University. "Money was leaving Europe and coming to the U.S."
That flight of capital intensified in the immediate run-up to World War II. Average long-term government interest rates hit a monthly low of 1.85% in 1941, according to an interest-rate history co-written by Mr. Sylla. Of course, that was one of the bleakest moments in modern history.
It may be difficult to imagine the economic situation deteriorating to the same degree. All the same, the yield on the benchmark 10-year Treasury note—while not strictly comparable with government rates from the 1940s—was 1.929% late Friday afternoon.
And the bond market is still sending signals that are far from cheerful. For instance, the yield curve—a measure of how much extra yield investors demand for holding longer-term debt—continues to decline, or "flatten" in the parlance of the bond markets, sending an ominous signal on the economy.
"It means that the market is expecting … basically an economy that is not going to be adding enough jobs to get the Fed concerned about rates for years and years and years and years," Mr. Volpert said.
Given the rush to safety during the quarter, even bonds that are slightly more risky provided less pop for investors than ultra-safe Treasury debt during the third quarter. The Barclays Capital Corporate bond index provided a total return of 2.9% during the three months ending on Sept. 30.
Perhaps unsurprisingly, some of the safest sectors of the corporate-bond market did much better. For example the highly rated utility bonds returned 7% during the quarter. Still, some observers say that they are seeing opportunities open up in corporate debt, given the overriding obsession with safety in recent months.
"Our base case is for sluggish economic growth in the U.S. to persist, but corporate health and corporate fundamentals are actually quite strong both in terms of liquidity and even the earnings outlook," said Christopher Molumphy, chief investment officer of Franklin Templeton Fixed Income Group, adding "we see increasing opportunity looking out over the longer term."
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