Unraveling the Mystery Behind U.S. Treasury Prices

Recent trading in U.S. government debt has puzzled even seasoned pros. BusinessWeek looks into the Treasury market's stratospheric pricing

By David Bogoslaw

In a season characterized by an ever-growing list of unprecedented events—from repeated capital infusions by the federal government into U.S. financial institutions to historically high market volatility—it's tempting to shrug your shoulders when you come across truly puzzling valuations that appear to ignore economic fundamentals. Still, the extent to which investor demand for U.S. Treasury bonds has sent prices soaring and yields plummeting seems to defy reason.

To get a sense of how much demand there is for fully-guaranteed government bonds, just look at prices over the past few months. The benchmark 10-year Treasury note was trading at a price of 106-22/32 for a yield of 2.974% on Nov. 26; the price was 102-06/32, and the yield 3.73%, on Sept. 2.

Try as you might to justify these moves by citing the seemingly bottomless hunger for cash at American International Group (AIG), to the collapse of Lehman Brothers Holdings, to Citigroup's (C) precarious position, the activity in the Treasury market sparks a flurry of questions. Inexplicably, investors don't seem concerned about the low-to-no yields they are getting for their money.

Here are some of the Treasury market's greatest puzzles:

Puzzle No. 1: The upward march of Treasury prices

Bill Larkin, portfolio manager for fixed income at Cabot Money Management in Salem, Mass., thinks Treasury bonds are probably one of the most dangerous trades for investors right now. The stock and bond markets are pricing in the worst economy in 30 years, with no Inflation expectations. "When you get into yields this low, and you get into this historic expensive zone, if you plan on holding them to maturity, you're fine. But in real terms, adjusted for inflation, you lose," he says.

Larkin says there's no doubt that the liquidity programs being enacted by the U.S. Treasury Dept. and the Federal Reserve will eventually stimulate growth and result in rising inflation, despite concerns about how effective these policies have been thus far in responding to the financial crisis.

Jim Sarni, managing principal at Payden & Rygel—an investment firm in Los Angeles that manages more than $50 billion in assets—calls the flight to quality into high-priced Treasury bonds a persistent disconnect between market fundamentals and market valuations on one hand, and people's desperation to avoid risk on the other. He notes how quick the Treasury has been to abandon certain strategies designed to spark lending and restore confidence in favor of new programs, without fully explaining to the public—or possibly even thinking through—how the proposed measures would actually work.

"As investors, we're all being bombarded by information that scratches the surface [in terms of trying] to solve the liquidity problems in the market," Sarni says. "Nothing is gaining traction because none of the details are known, and that's manifesting itself in people being skittish, which is driving them to the safest thing out there until there's more certainty about what's going on."

The latest announcement on Nov. 25 was that the Federal Reserve plans to buy up to $500 billion worth of mortgages bonds guaranteed by Fannie Mae, Freddie Mac, and Ginnie Mae, as well as an additional $100 billion of the corporate debt of Fannie, Freddie and the Federal Home Loan Banks.