Get Out Now!

Get Out Now!

By Andrew Bary, Barron's | 9 January 2009

The bubble in Treasuries looks ready to pop, sending prices on government debt sharply lower. But just about every other corner of the bond market beckons— and could provide competitive returns with stocks, even if the equity markets have a strong 2009. The biggest investment bubble today may involve one of the safest asset classes: U.S. Treasuries. Yields have plunged to some of the lowest levels since the 1940s as investors, fearful of a sustained global economic downturn and potential deflation, have rushed to purchase government-issued debt.

The market also has been supported by comments from the Federal Reserve that it, too, may buy long-term Treasuries. As a result, the benchmark 10-year Treasury note yields just 2.40%, down from 3.85% as recently as mid-November. The 30-year T-bond stands at 2.82%, and three-month Treasury bills were sold last week for a yield of just 0.05%.

Many investors argue it's dangerous to buy Treasuries with such low yields. While a holder can expect to get repaid in full at maturity, the price of longer-term Treasuries could fall sharply in the interim if yields rise. The 30-year T-bond, for instance, would drop 25% in price if its yield rose to 4.35%, where it stood as recently as Nov. 13.

The bear market may have begun Wednesday, when prices of 30-year Treasuries fell 3%. They lost another 3% Friday. "Get out of Treasuries. They are very, very expensive," Mohamed El-Erian, chief investment officer of Pacific Investment Management Co., warned recently.

Pimco runs the country's largest bond fund, Pimco Total Return (ticker: PTTRX). Treasuries offer little or no margin of safety if the economy unexpectedly strengthens in 2009, or the dollar weakens significantly, or inflation shows signs of reaccelerating. Yields on 30-year Treasuries easily could top 4% by year end.

The chief risk to the Treasury market stems from the potentially inflationary impact of both the Federal Reserve's super-accommodative monetary policy, which has dropped short rates close to zero, and the enormous looming fiscal stimulus from the federal government. It also may take higher yields to attract investors— particularly foreigners— as the Treasury seeks to fund an estimated deficit of $1 trillion or more in the coming year. One sign of trouble for treasuries is the resilient price of gold, which has risen $150 an ounce since late October, to $880 an ounce, despite weakness in most commodity prices.

Investors rightly see gold as an appealing alternative to low-yielding Treasuries and virtually nonexistent yields on short-term debt as the government cranks up its printing presses. Gold was up $45 an ounce last year, while oil was down 50%. Another worrisome indicator: The dollar has weakened recently, losing 10% of its value against the euro in the past month.

It is difficult for individuals to sell Treasuries short, but two exchange-traded funds, the Ultrashort Lehman 20+Year Treasury Proshares (TBT) and the smaller Ultrashort Lehman 7-10 Year Treasury Proshares (PST), offer a bearish bet on the Treasury market. Both these securities are designed to move at twice the inverse of the daily price movement in Treasury notes and bonds. Since the summer, the 20+Year Proshares has fallen almost 50% as Treasury prices have surged. If Treasury yields return to June levels, the ETF could double in price.

Another alternative for T-bond bears is to sell short the iShares Barclays 20+Year Treasury Bond Fund (TLT), an ETF that gives exposure to the long-term government-bond market. While Treasuries look rich, other parts of the bond market beckon, including municipals, corporate bonds, convertible securities, some mortgage securities and preferred stock. The average junk bond now yields 20%, compared with 9% at the start of 2008. Triple-A-rated munis with 30-year maturities are yielding about 5.25%, almost double the yield on 30-year Treasuries. The yield differential between the two markets is unprecedented. Until this year, munis almost always yielded less than Treasuries because of their tax benefits.

Long-term corporate bonds with investment-grade ratings of triple-B now yield an average of 8%, nearly 5.5 percentage points more than Treasuries of comparable maturity. They rarely have yielded more than four points above government debt. Preferred stock of financial companies such as Bank of America (BAC) and Morgan Stanley (MS) yields 9% or more, and many preferreds carry tax advantages because their dividends, like those on common shares, are subject to a 15% federal tax rather than rates on ordinary income.

"The only part of the bond market that you need to be bearish on is Treasuries," says Jim Paulsen, chief investment strategist at Wells Capital Management in Minneapolis. "The other sectors are attractively priced." A bearish stance toward Treasuries and a bullish one toward the rest of the bond market represents the consensus view.

Most equity and bond analysts surveyed last month by Barron's projected the Treasury 10-year note would carry a yield of 3% or higher by the end of 2009 ("Out With the Old," Dec. 22). At the same time, it's hard to find bears on corporate bonds. It's nice to be contrary. Sometimes, however, the consensus view is right.

Lately corporate and municipal bonds have rallied, with Merrill Lynch's junk-bond index gaining more than 6% in December, the strongest monthly increase since 1991. Most yield disparities between corporate and municipal bonds and Treasuries still are off the charts relative to historical ranges. Perhaps more important, absolute yields on corporate and municipal debt look attractive relative to inflation, and even stocks.

It's tough to estimate the current price/earnings ratio on the Standard & Poor's 500 stock index because the profit outlook is so uncertain amid a recession. Assume $60 in S&P earnings for 2009 and the index, now about 925, trades for 15 times forward profits, not cheap by historical standards. Equity bulls are betting the $60 estimate proves conservative, and that corporate earnings grow sharply in 2010. The S&P likely earned about $72 in 2008, before massive write-offs.

The smart money is crowding into the corporate-bond market, including investment-grade debt, junk bonds and so-called leveraged loans, which are bank loans to debt-laden companies such as Neiman Marcus, Georgia-Pacific and First Data. Leveraged loans, which are senior to junk bonds, now trade for an average of about 70 cents on the dollar and carry yield to maturities of 10% to 15%. Many equity-oriented hedge funds and mutual funds have added to their corporate-bond holdings because of enticing yields.



"The argument is that the credit markets have to straighten themselves out before stocks rebound," says Marty Fridson, who heads Fridson Investment Advisors in New York. "Investors will rotate into the credit markets and then into stocks when they look more promising." Some investors argue the credit markets are discounting a grimmer economic and financial outlook than the stock market, and thus more opportunity lies in bonds.

There clearly is risk in corporate bonds. Junk-bond default rates, which ran at just 3.4% in the past 12 months, are certain to spike in 2009. Moody's Investors Service expects the U.S. junk-default rate to top 10% in the next year.

Yet, with a 20% average yield, junk bonds could provide nice returns, even in that scenario. "You're buying the market at a pretty steep discount," Fridson says. "You're getting compensated for a severe escalation in defaults."

The average junk issue trades for less than 60 cents on the dollar, and some bonds, like those issued by the bankrupt Tribune, have sunk to just pennies on the dollar. Defaults might have to run at a cumulative 50% rate in the next five years and recovery rates average just 30 cents on the dollar— versus a historical average of about 40 cents— for investors to get sub-par returns. The junk market declined about 27% in 2008, by far the worst showing in the past 20 years.

If history is any guide, 2009 should be better because down years like 1990 often have been followed by big gains. It wouldn't take a lot for junk to return 20% in 2009, given the elevated yields throughout the market. There are plenty of ways to play the junk sector, including ETFs like the iShares iBoxx $ High-Yield (HYG), open-end funds like Fidelity Capital and Income (FAGIX) and many closed-end funds, including some that trade at double-digit discounts to their net asset value.

A complete list of closed-end funds starts on page M45. The Loomis Sayles Bond fund (LSBRX), which owns a mix of U.S. and foreign government bonds, investment-grade corporates and junk debt, fell 22% last year. The fund, co-managed by bond veteran Dan Fuss, now has a current yield of around 11%.

Convertible securities, which were bashed in 2008 in part from forced selling by leveraged hedge funds, offer a nice combination of yield and equity kickers. Issuers include Citigroup (C), Chesapeake Energy (CHK), Vornado Realty Trust (VNO) and Transocean (RIG). Ford Motor 's 4.25% convertible bond due in 2036, trading for about 27 cents on the dollar for a 27% yield to an optional redemption date in 2016, is a good alternative to the common stock (F), which yields nothing. Vanguard, Fidelity and Putnam all have open-end convertible mutual funds, and there are many closed-end funds, including some trading at discounts to their net asset values.

The backdrop for municipal bonds is troubled because state and local governments are getting squeezed by lower tax revenue and sizable outlays for basic services and other needs. Investors are getting compensation via 5% to 6% yields on top-grade long-term securities and high single-digit to low-double-digit yields on Baa-rated bonds from a range of issuers, including hospitals and state-issued tobacco-revenue debt. Risk-averse investors should stick with state general-obligation bonds or essential-service revenue bonds, which rarely default.

The giant Vanguard Intermediate Tax-Exempt fund (VWITX) was unchanged in 2008, while many long-term funds were down 5% to 10%. There are numerous closed-end muni funds trading at double-digit percentage discounts to their NAVs. Closed-end funds carry more risk because of financial leverage. Their yields generally top 6%.

Low-grade munis were bashed in 2008, and no big fund was harder hit than the Oppenheimer Rochester National Municipals (ORNAX), which specializes in riskier securities. It fell almost 50% on the year, two to three times more than other large funds focused on high-yielding munis. It now carries a tempting current yield of 13%.

While the mortgage market was the root of much of Wall Street's troubles in '08, the country's largest mortgage fund, the Vanguard GNMA (VFIIX), turned in a good year, rising about 7%, by sticking with government-guaranteed Ginnie Maes and avoiding riskier investments.

The problem with Ginnie Maes now is that yields have fallen to about 4%, which will make it tough for investors to generate decent returns barring further rate declines. The better opportunities probably lie in riskier mortgage securities that lack a government backing, including battered issues secured by subprime loans and so-called Alt-A loans, which are a notch above subprime.

This area is a minefield, and difficult to play directly. It is probably best to stick with a mutual fund like the TCW Total Return Fund (TGMNX), a mortgage fund run by long-time specialists Jeff Gundlach and Phil Barach. About half its assets are in securities that lack Ginnie Mae, Freddie Mac or Fannie Mae backing. It was up about 1% last year.

For those seeking the safety of Treasuries, the best bet probably is TIPS, or Treasury Inflation Protected Securities. They provide much better yields than ordinary Treasuries unless inflation disappears. The 10-year TIPS yield 2.23%, versus 2.40% for the regular 10-year Treasury. The so-called breakeven annual inflation rate that would result in similar yields on the two securities is just 0.17% annually (2.40% minus 2.23%), versus a typical spread of more than two percentage points.

TIPS offer a nominal yield, plus principal indexed to inflation. If inflation is 3% annually in the next 10 years, in line with the historical average, TIPS will return 5.25% (the 2.25% nominal yield plus 3% for the inflation component). There are several ways to invest in TIPS, including through open-end mutual funds such as the Vanguard Inflation-Protected Securities fund (VIPSX), and an ETF, the iShares Barclays US Treasury Inflation Protected Securities Fund (TIP).

Despite the risks in government bonds, there is a case for the sector. David Rosenberg, the Merrill Lynch economist who correctly called the housing bubble and resulting economic downturn, wrote in a recent client note titled "The Frugal Future" that the current recession resembles the vicious downturns prior to World War II more than the mild downturns since. The credit crisis and what Rosenberg calls "imploding" household net worth in the U.S. are apt to make it linger through 2009, when the economy could contract 3% in real terms, and perhaps into 2010.

Rosenberg thinks the yield on the 10-year Treasury note might bottom at 1.5%. "Sustained negative wealth effects from the slide in housing and equity prices will reinforce the uptrend in the personal saving rate, creating a highly deflationary environment as job losses mount and push the unemployment rate up toward 8.5% in the coming year," he wrote.

It may take such a grim scenario to support Treasuries, given their lofty prices and super-low yields. More likely, the combination of U.S. fiscal and monetary stimulus will lift the U.S. out of recession by the second half of next year [[oh, that infamous 'second half recovery' scenerio: normxxx]] and the global economy will expand in 2009, albeit at a slower pace than in 2008. Morgan Stanley economists see global growth of 0.9% in 2009, boosted by 3%[!?!] growth in the developing world. [[Oh, the Chinese and the mini-Tigers will save us! Has MS checked with China recently? Last I heard, they'd just about stopped importing stuff…: normxxx]]

If the more bullish economic and financial scenarios come to pass, interest rates— and Treasury yields— likely will rise [[and the price of Treasuries will likewise decline: normxxx]]. In any event, the Treasury would do well to take advantage of today's rock-bottom yields and significantly increase the issuance of 30-year bonds. One reason the 30-year yields so little is scarcity value.

Of the $874 billion of Treasury notes and bonds issued in 2008, just $35 billion was 30-year debt, according to analysts at Wrightson ICAP in New York. Given its huge borrowing needs, the government arguably ought to issue at least $100 billion of 30-year debt this year and perhaps as much as $200 billion. Treasury bills cost the government next to nothing now, and for better or worse, near-zero rates almost certainly won't last.