A Bond Back From the Grave


By Palash Ghosh It looks like reports of the long bond's demise have been greatly exaggerated. In May, the U.S. Treasury Dept. said it may reissue 30-year bonds as the government grapples with financing record budget deficits. (The long-bond program was suspended in October, 2001.) The about-face reflects dramatic changes in the nation's geopolitical profile following the costly obligations of wars in Iraq and Afghanistan, the recession of 2001, President Bush's massive tax cuts, and a proposal to privatize Social Security.

When 30-year bonds met their demise in late 2001, the economy looked very different. Congress predicted years of surpluses, which would eventually wipe out the national debt, and hoped to save money by shortening the average maturity of public debt and no longer issuing higher-yielding long-term debt.

SURPLUS REVERSED. But after posting a handsome surplus of $236 billion in 2000, the fourth straight year of such prosperity, the government incurred deficits of approximately $400 billion in each of the next four years, including a record $412 billion in 2004. The figure is expected to reach $427 billion this year. Now, the proposed return to 30-year bonds suggests the government believes the deficit will continue to grow, exacerbated by baby boomers on the cusp of retirement.

With short-term interest rates steadily rising, the government is finding it more attractive to move federal debt away from short-term financing. Also, as the gap between short-term and long-term interest rates narrows, it makes more sense to borrow long.

By issuing new 30-year bonds, the Treasury could reduce its cost of borrowing over the long term by attracting new investors, diversifying its issued debt, and reducing its exposure to possibly higher short- and medium-term rates.

"REASONABLE DEMAND." Assuming the plan goes through, the Treasury said it would conduct two auctions next year, the first in February, 2006. Each would value between $10 billion to $15 billion. A final decision on the issuance will come in early August, though many consider it a fait accompli.

James Cusser, sole manager of the $243-million Waddell & Reed Advisors Government Securities Fund/A (UNGVX) and the $676-million Waddell & Reed Advisors Bond Fund/A (UNBDX), predicts great demand for these new 30-year bonds, "particularly from defined-benefit pension funds and insurance companies...seeking to match their long-term obligations with long-term assets."

Brian Howell, co-manager of American Century Strategic Allocation: Moderate (TWSMX) and senior portfolio manager for taxable bond strategies, says he sees a "reasonable demand" for these new bonds from typical long-term investors, particularly as a

duration instrument.

NOT FOR EVERYONE. "As a pure duration play, there is no substitute for these 30-year securities," Howell says. "Bond fund managers would also likely invest in these securities -- again, to add duration to their portfolios." He points out that, while 30-year bonds may not make an ideal choice for individual investors, "they might appeal to some investors who are looking for long-term secure income, a little yield, and not much risk."

Gary Arne, managing director, financial services and global practice leader for fund ratings & evaluations at Standard & Poor's, says that because of the 30-year Treasury's long duration, it offers less risk from a price and total-return perspective when long-term rates are headed down, not up. Arne adds that most bond-fund managers are currently "sticking pretty short now, most likely to avoid market price declines when long-term rates increase." But, so far this year, long-term rates have not moved, he notes.

"Most individual investors should not be buying 30-year bonds," says Scot W. Johnson, lead portfolio manager of the $865-million AIM Intermediate Government Fund/A (AGOVX) and the $312-million AIM Limited Maturity Treasury Fund/A (SHTIX). When investors buy 30-year bonds, he explains, they limit the stability their bond holdings provide. "For any movement in interest rates, you can expect 30-year bond prices to move twice as much as prices on 10-year notes. In exchange, you get only about 35 basis points more in yield. For me, that's not a good risk-return trade-off."

BENEFITS OF BALANCE. One of the major themes in long-term bond investing is that long-term rates have remained at historic low levels, even as the Fed has steadily boosted short-term rates for the past year. As a result, the yield curve, the gap between short- and long-term interest rates, is flattening. While Fed policy remains the sole determinant of short-term interest rates, longer-term rates reflect a number of factors, including expectations for economic growth, inflation trends, and monetary policy.

Cusser says he believes longer-term interest rates are headed up. "If we assume the economy will grow above 3% annually, and long-term rates rise, buying a long-term bond might not be a good idea," he says. "However, with a long-term investment perspective, I like to keep a barbelled portfolio, with both longer-term and shorter-term securities, although my average duration will closely match that of my index." Cusser adds, however, that most of his long-end exposure is in corporate debt, not Treasuries.

Johnson also believes long-term rates are headed higher. Rather than owning intermediate maturities (3 to 5 years), his funds have both shorter paper and longer paper. "The 30-year bond would fit into our strategy, because it would provide a more liquid market in the long end of the Treasury curve," he says.

LOCKED-IN RATE. Cathy Roy, chief investment officer for fixed income at Calvert Group, says the biggest danger inherent to the 30-year bond relates to duration risk. "The movement of interest rates has a much bigger impact on a long-term security than a shorter-dated one," she says. "I think we're in an environment of rising interest rates, both short-term and long-term. As inflation creeps up, longer-term rates will likely rise."

Johnson notes the biggest risk with investing in 30-year bonds lies in their price volatility. "For a 1% rise in interest rates, the price of a 30-year bond will fall about 15%," he says. "For that same 1% rise in rates, the price of a 10-year note will only fall about 8%. You also want to consider that you're locking in an interest rate for 30 years. In 5 years, are you going to be glad you're collecting a 4.375% coupon for another 25 years?"

The current market of 30-year bonds totals less than $20 billion. As a result, a tremendous amount of supply would come on line next year, leading some observers to worry that prices of these bonds would suffer. On the day the government announced a possible resumption, the price of existing 30-year bonds dropped, pushing the yield to 4.59%, from 4.48%. However, as Gregory Whiteley, a portfolio manager in charge of U.S. government strategies for TCW, points out, after the initial reaction, 30-year bond prices recovered and yields declined again, perhaps implying that investors expect long-term rates will remain modest, despite the new supply.

FUND CANDIDATES. "I'd say the near-term environment is reasonably favorable for long-term bonds," says Whiteley. "Economists have been calling for an increase in interest rates and, with the exception of short-term rates, this hasn't occurred. We've seen a little blip of inflation, but it won't be a problem over the next year. Plus, there are several sources of demand for long-term bonds."

Where can investors turn if they wish to "go long"? They can find numerous long-term government-bond funds, many of which will likely invest in 30-year bonds if they become available next year. The best-performing funds from this sector are listed below for the one-, three-, and five-year periods. In addition, there is an exchange-traded fund, the $669-million iShares Lehman 20+ Treasury Bond Fund (TLT) from Barclay Global Investors. As of Mar. 31, it had 21.3% of its assets invested in securities with maturities between 25 and 30 years, with an average weighted maturity of about 23 years.

TOP-PERFORMING LONG-TERM GOVERNMENT BOND FUNDS

Fund

Return (%)

S&P

3-Year Overall Rank Rank

ONE YEAR

American Century Target Maturity 2030/Inv (ACTAX)

+43.51

2

American Century Target Maturity 2025/Inv (BTTRX)

+36.88

3

American Century Target Maturity 2020/Inv (BTTTX)

+26.63

3

ProFunds:US Government Plus/Iv (GVPIX)

+25.25

N.A.

Wasatch-Hoisington:US Treasury Fund (WHOSX)

+24.42

2

Average Fund In Sector

+11.36%

THREE YEARS

American Century Target Maturity 2030/Inv (ACTAX)

+20.16

2

American Century Target Maturity 2025/Inv (BTTRX)

+18.11

3

American Century Target Maturity 2020/Inv (BTTTX)

+15.74

3

PIMCO Funds:Real Return Asset/Ist (PRAIX)

+13.15

4

Wasatch-Hoisington:US Treasury Fund (WHOSX)

+12.71

2

Average Fund In Sector

+9.56%

FIVE YEARS

American Century Target Maturity 2025/Inv (BTTRX)

+13.90

3

American Century Target Maturity 2020/Inv (BTTTX)

+13.35

3

American Century Target Maturity 2015/Inv (BTFTX)

+11.89

3

PIMCO Funds:Long Term US Government/Ist (PGOVX)

+11.26

3

Wasatch-Hoisington:US Treasury Fund (WHOSX)

+11.20

2

Average Fund In Sector

+9.99%

Source: Standard & Poor's. Total returns are in U.S. dollars and include reinvested dividends. Data as of 5/21/05. Ghosh is a reporter for Standard & Poor's Fund Advisor


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