Ramblings of a Portfolio Manager

Why Treasuries Are Risky

When PIMCO’s Bill Gross speaks, people listen...especially when the subject is bonds. And well they should. As the co-founder of one of the World’s largest fixed income investment management firms, with over $1 trillion in assets under management, he might just know a little something about that asset class. So it was with tuned ears that we listened to his pronouncement last week that, in his opinion, the almost three-decade rally in fixed-income has run its course. Said Gross in an interview with CNBC last Thursday, “Let’s suggest the economy looks good, that risk assets — whether it’s high-yield bonds or whether it’s stocks — have a decent return relative to the potential of declining bond prices... I’ll go with the stock market.” Gross went on to say that he believes stocks may outperform bonds over the next three months. It was a striking statement from someone who makes his living managing bond portfolios and whose PIMCO Total Return Bond Fund has grown to be the largest mutual fund in history, at $214 billion, thanks to fearful investors fleeing equities to the safety of bonds. He reiterated his statement in a later Bloomberg interview in which he stated that “bonds have seen their best days” and that the prospect of a strengthening U.S. economy and rising interest rates makes an “argument to not own as many bonds.” By the way, he’s a man who puts his money where his mouth is as PIMCO announced in December that it would now begin to offer stock funds.

To many investors, that the investment world’s proclaimed “Bond King” is now touting stocks over bonds should be a wake-up call. Since the 2008 financial crisis, investors have fled stock funds and poured cash into US Government bond and other fixed-income funds in search of safety. That trend continued throughout 2009 causing many investors to miss the US stock market’s nearly 74% rise, the biggest rally since the 1930’s. Even thus far in 2010 bond mutual fund inflows are 5 times greater than they were at this time last year. Part of the reason for the rush to bond funds is that investors are reaching for higher returns with money-market funds yielding close to zero, but there is still a large component of fear to the move—fear over the future of the world economy and its potential ill effects on equities. Despite a slew of positive economic and company-specific data from around the globe, investors are still eschewing risk. What most don’t understand, however, is that there are many types of risk--among them inflation risk, and its corollary interest rate risk, are very real, sizeable, and potentially devastating to the unwary investor.

Investors have been making money in bonds for so long they assume that it will continue forever. It can’t. US Treasuries have rallied for almost three decades, pushing the yield on the 10-year Treasury note from a high of 15.8 percent in September 1981 to a record low of 2.03 percent in December 2008 during the height of the financial crisis. Since their December lows, however, 10-year US treasury yields have been creeping slowly upward and last Thursday the bond market got slammed after a poor Treasury auction brought the yield on the 10-year to 3.89%, its highest level since June. Fears of high US debt levels and pending inflation (from stronger economic growth) are making bonds less attractive, pushing down prices and raising yields. Currently, with inflation near zero, both the real and nominal rates of return on US Treasuries is about equal to their current yield--3.9% in the case of the 10-year--and, of course, someone holding a 10-year note to maturity has a very good chance of earning that 3.9%. However, as inflation rises, the real rate of return on that investment will decline and as US interest rates climb (either due to inflation or sovereign risk fears), Treasury prices will drop, giving bond investors a double-whammy of a declining real long-term yield to maturity plus a potential annual loss in their bond portfolios, something many have never seen. Because so many investors have gone so long without losing money in Treasuries, whether they will stay the course and continue to pour money into fixed-income funds is now in question.

According to Morning Star, bond funds almost never outperform equity funds over a decade, as they did in the 10 years ending in March 2009, and they have never done so in two consecutive 10- year periods. That little statistic is striking. Just as “trees don’t grow to the sky” is a wise stock valuation philosophy in equity investing, so too is it true with bond prices in the fixed-income world. If we go through a period where investors realize that they can, in fact, experience annual losses in Treasuries and other “safe” fixed-income investments, we may see an exodus from bond funds. And with inflation and interest rates on the rise it’s a good bet that all that money will find a home in equities.