December 15, 2011 8:07 pm
US Treasuries: Surprisingly sturdy
Strong demand has brought Treasury bonds a banner year
Back in February, traders on the floor of Royal Bank of Scotland in Connecticut gasped in shock at their screens. What had been expected to be a difficult sale of US government debt instead attracted record demand, led by foreign investors.
The strength of buyer appetite in that $24bn auction of 10-year Treasury paper produced a result that many would ignore to their great cost. As 2011 draws to a close, one thing is becoming clear: against a backdrop of an escalating crisis in the eurozone and lacklustre American growth, buying boring US government bonds has been the right call for investors in search of a safe haven.
The strong performance of Treasury debt this year, with gains of 30 per cent for owners of long-term bonds alone, has left plenty of smart investors with egg on their faces. While there were a host of perfectly sound reasons to start 2011 with a negative view on the bond market, the relentless decline in Treasury yields and rise in prices has compelled many to reverse course and become buyers.
The continuing clamour for Treasuries comes amid a bruising year for many other assets, with US and European equities in negative territory and sharp falls in commodity prices.
What troubles investors and policymakers is the growing concern that low US bond yields and the poor performance of equities reflect how the world’s largest economy is struggling to overcome the bursting of the credit and mortgage bubble. Debt-strapped consumers and a fragile banking system raise disturbing parallels with Japan, whose economy has stagnated for two decades since its property bubble popped in the early 1990s.
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“Many investors did not understand the situation the US and Europe faced at the start of the year,” says Richard Cookson, chief investment officer at Citi Private Bank. “We are in a Japan-style situation, where the private sector is saving.”
For investors who at the start of the year failed to see the parallels between Japan’s earlier experience and that of the US since 2008, and believe Treasury yields are too low, a bigger concern looms. Fiscal austerity is fashionable in Washington and the lack of government stimulus could limit the recovery of the economy in 2012 and maintain Treasury yields near record low levels for some time.
Mr Cookson, who advised wealthy investors to be heavily exposed to Treasuries at the start of 2011, says his call went strongly against the investing crowd, which believed Treasury yields had seen their bottom. They were seeking better returns from equities.
A February survey of fund managers by Bank of America Merrill Lynch found that more than two-thirds of the 188 global asset managers polled were overweight in global equities, the highest level since the survey started in 2001. Close to the same proportion were underweight in bonds.
The fear, particularly in the US, was that once the Fed completed its purchase of Treasuries in June via its second round of quantitative easing – so-called QE2 – yields would rise sharply as the largest buyer in the bond market moved to the sidelines. In bond investing, yields and prices move in corresponding opposite directions. The escalation of the US deficit since the onset of the financial crisis and political wrangling over how to address long-term pension and health obligations were also causing some to question the wisdom of owning Treasuries at low yields.
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One of the most influential bond market figures had already made up his mind. Unknown to investors at the time, Bill Gross of Pimco was liquidating exposure to US government paper in his $240bn Return Fund, the largest individual bond fund in the world. When that action became public in March, it served only to affirm the consensus view that US government bonds were set for a poor year in 2011.
Explaining his stance, Mr Gross told investors that with most of the $9,000bn in publicly-issued Treasury notes in the hands of foreign sovereign investors or the Fed, “the legitimate corollary question is – who will buy Treasuries when the Fed doesn’t?” Mr Gross was also concerned that inflation, which erodes the fixed payments received as interest on bonds, would soon rise and spark the selling of Treasuries; investors would demand a higher return to compensate for that risk.
The judgment appeared plausible at the time as investors fixated on the potential for trouble in Washington over raising the nation’s debt ceiling. That protracted debate incurred the displeasure of rating agencies already alarmed at the long-term consequences of high federal borrowing.
Yet, even against that gloomy backdrop, Treasuries still found willing buyers. It was a trend that soon tested the bearish market consensus, particularly as economic recovery proved feeble. Jeffrey Gundlach of Doubleline Capital, this year’s best performing bond manager, says that the “major mistake most investors made over the past 12 months” was to assume that the rundown in stimulus spending, the ending of QE2 and the fallout from the debt ceiling impasse would be negative for Treasuries.
Citi’s Mr Cookson at the start of the year had no doubt that the US economy was running the risk of mirroring a Japan-style morass of weak post-bubble growth. “The consensus is always wrong – equity analysts are far too optimistic and bond guys are far too bearish on their market.”
As early as March, cracks in the consensus that Treasuries were a poor investment became apparent. The Japanese earthquake and tsunami sparked a brief bout of buying in Treasuries, sending yields lower as investors sought a haven in which to park their money. This first test of the consensus view revealed its inherent flaw. Beyond being an investment, US Treasuries are the bedrock of international debt markets. In a world awash with debt, Treasuries are the hub and other market interest rates are the spokes, priced and valued against the US benchmark.
In times of stress, buying Treasuries, German bunds and UK gilts is the safety-first option. As events transpired in 2011, there were times when owning such assets was just about the only action that allowed investors to sleep at night.
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There are two ways to view Treasuries when it comes to investing. One is to focus on the fixed rate of return as income and prospects for future price appreciation. At the start of the year, many investors believed the yields on offer were too low and the potential for further declines was limited.
That, however, ignored Treasury debt’s haven role. When investors flee other markets they park their money in Treasuries, and this characteristic of investment behaviour is why some argue that US government debt should always be part of a portfolio.
“Portfolios need to own at least some amount of long-term Treasury bonds, even today at their very low yield levels,” says Mr Gundlach.
Against the backdrop of the eurozone debt crisis, though, there was an argument that the US also faced being held accountable by investors worried about high government spending and rising deficits.
Known as “bond vigilantes”, these investors have in the past sought to hold governments to account by demanding higher interest payments for their borrowing. That occurred in the US in 1993 and ultimately compelled the administration of Bill Clinton to focus on reducing the budget deficit.
But instead of bringing the US to account, the vigilantes have focused on Europe, thus helping boost the appeal of Treasury debt. By August, as investors rushed into bonds even after Standard & Poor’s deprived America of its triple A credit rating, the point was impossible to miss.
At the same time, fading prospects for economic recovery had caused even Mr Gross to abandon the idea that much higher inflation was a greater risk for bond investors. Now, the danger appeared to be sluggish economic growth that over time is followed by lower inflation.
During the summer he would start buying Treasuries again. “Do I wish I had more Treasuries? Yeah, that’s pretty obvious,” Mr Gross told the Financial Times in August after he had resumed buying.
Indeed, he has bet on a further fall in interest rates by buying very long-dated government bonds. That began after the Fed announced in September that it would buy long-dated Treasuries in a move known as Operation Twist. It is a strategy designed to lower interest rates for homeowners and companies and thus boost the economy. The return of the Fed as a big buyer of long-term bonds has placed a ceiling on interest rates and helps maintain downward pressure on 30-year bond yields.
In conjunction with its intention not to raise short-term rates from near zero for at least another 18 months, the central bank’s policies are seen acting like a workbench vice, squeezing short and long-term yields closer together at low levels. Against expectations of lacklustre economic growth next year and uncertainty over both the outcome of the eurozone crisis and China’s outlook, it raises the prospect of a Japan-style malaise with low bond yields in 2012.
Mr Cookson doubts the US economy can accelerate in the coming year and reverse the decline in Treasury yields. “Low yields are here for some time,” he says. Or as Jack Ablin, chief investment officer at Harris Private Bank, puts it: “The US will be like Japan for the next couple of years due to the contraction in credit and debt overhang.”
This week at RBS, William O’Donnell, who was among those who did a double-take at his screen after the 10-year sale early in the year, says the latest auctions reveal “just how much the lack of high-quality assets in the world has pushed safe haven flows into US Treasuries”.
If nothing else, that keeps smiles on the faces of the buyers from early 2011. “If you bought at the February auction you have seen a total annualised return in the vicinity of 25 per cent,” he adds.
Fund managers - a new man at the top
The king is dead, long live the king.
For the past decade there was one voice in the bond market that mattered more than any other investor, write Dan McCrum and Michael Mackenzie. Bill Gross, co-chief investment officer for Pimco, ran the world’s biggest bond fund yet performed like he managed millions of dollars, not hundreds of billions.
Mr Gross was dubbed fixed income manager of the decade by Morningstar, a research group, for consistently ranking in the top tier of bond managers. His $240bn Total Return Fund, Pimco’s flagship investment vehicle, is several times larger than its closest peer and its success has been central to Pimco’s reputation as the asset manager to watch. Mr Gross also gained outsize influence with colourful investment commentaries that brought the dry mathematics of fixed-income investment to life.
“Part of the reason why we’ve been successful,” he told the Financial Times in March, was that “we’ve been willing to go on TV. We’ve been willing to write, we’ve been willing to make statements that were somewhat aggressive and controversial.”
Yet this year that strategy misfired. Mr Gross not only missed the trade of the year – buying US Treasuries – he actively counselled against it. His fund has had its worst run since 1995, producing a return of just 3.5 per cent.
The man who picked up the crown is Jeffrey Gundlach. His DoubleLine Capital runs the first and second placed bond mutual funds in the US this year, according to Morningstar.
Mr Gundlach has long been a contender. A past nominee for Morningstar’s manager of the decade award, he was chief investment officer of TCW, another fund manager, an acrimonious departure in 2009 that ended in the courts.
With fellow refugees from TCW he started DoubleLine, which has become the fastest growing mutual fund in at least two decades, according to Strategic Insight, a research group. From $6.7bn in assets under management at the start of 2011, it is on course to finish the year with $21bn.
Mr Gundlach is adamant that the global economy will remain sluggish. He expects further market dislocation next year thanks to events in Europe.
But the new bond king is not out to build an empire, saying that DoubleLine will likely close to investors when it hits $50bn in assets. “I don’t really want to have 20 offices around the world, 2,000 people,” he says. “I don’t really think it’s any more lucrative than the model that I’m talking about, and it’s just the quality of life.”
Copyright The Financial Times Limited 2011
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