Markets & Finance

Treasuries: Smart Plays in Tricky Times


A flight from safety cut government debt prices, but T bulls say bears are taking recovery for granted. Both sides are armed with ETFs

So much for the Treasury bubble. Yields on the 10-year Treasury note fell to 2% in December, as bond prices rose 12% over just three months (bond prices and yields move in opposite directions). Now, however, investors are dumping Treasuries as quickly as they purchased them. The price of the 10-year note has declined about 10% from its December high and yields on May 27 were 3.76%—near pre-crisis levels.

Market pundits offered explanations for the Treasury-market slump, ranging from jitters about the U.S. government's ability to keep its AAA credit rating to hedging activity by mortgage-bond players. But the basic reason investors are selling U.S. government debt is this: They don't need what Treasuries offer—namely safety and liquidity, albeit with negligible returns.

The price of Treasuries now depends more on economic and market fundamentals than investor fear. But the fundamentals themselves are unclear, and this has resulted in some uncertainty about strategy. Some market players regard Treasuries as still dangerously overvalued, especially if the economy is on the cusp of a recovery.

On the other side of the fence are investors who see misplaced optimism in the recent rallies in stocks and corporate bonds. For them, recovery is still off in the distance and at these prices, Treasuries provide good value for the money.

bears: Shun—or short—Treasuries

Let's look at the bears' argument first. The U.S. government is selling massive amounts of new Treasury notes and bonds—$1 trillion at last count. But buyers aren't interested in anything but short-dated Treasuries. Even with the most recent rise in rates, yields on the 10-year note are still well below even the most recent 10-year average of 4.32% and might not be enough to entice investors. At the same time, the economy appears to be bottoming and inflation is likely to return with economic growth.

The upshot: Treasury rates must continue to rise, causing the price of the bonds to fall. "Investors probably shouldn't be owning Treasuries right now." says William Larkin, fixed income portfolio manager at Cabot Money Management in Salem, Mass.

From the bears' point of view, the best strategy for buy-and-hold investors may simply be to stay away. Those with a trading mentality can short the iShares Barclays 20+ Year Treasury Bond ETF (TLT), notes Matthew D. McCall, president of Penn Financial Group. Two other ETFs can double a short bet: the ProShares UltraShort 7-10 Year Treasury (PST) and the UltraShort 20+ Year Treasury (TBT) funds.

Not so fast, say Treasury bulls. The recession isn't over, but the markets are acting as if it is. Stocks, corporate debt, and even junk bonds have rallied on expectations that a recovery is imminent. But if the good news is priced in, all that's needed to send investors fleeing back to the safety of Treasuries is a spike in U.S. job losses or a major escalation in a geopolitical hot spot, for instance.

How many Treasuries will the Fed buy?

The real wildcard could be the Federal Reserve. Fed chairman Ben Bernanke initially planned to purchase $300 billion in Treasuries to keep rates low. If the Fed decides to raise that to $1 trillion at the next Federal Open Market Committee meeting later in June, rates will certainly fall, at least in the short term.

Taking the bullish view, the iShares Barclays 3-7 Year Treasury Bond Fund, an exchange-traded fund, makes sense for buy-and-hold investors. Active traders who think Treasury prices have fallen too far can buy the iShares Barclays 20+ Year Treasury Bond ETF and sell on a rebound, says Ari Bergmann, principal at Penso Capital Markets.

A safer choice, however, could be to split the difference between the two camps. Said Pimco (AZ) bond guru Bill Gross in a monthly note posted on the firm's website on June 3: "Bond investors should…confine maturities to the front end of yield curves where continuing low yields and downside price protection is more probable."

That could point investors toward the 5-year note, which now yields around 2.4%, up from 1.6% just a few months ago. If the recovery proves to be less substantial than expected, it would gain in value, though not at much as the 10-year or 30-year bonds. But if inflation does return, its short duration means investors will face less downside risk. Says Don Quigley, portfolio manager of the Artio Total Return Bond Fund (BJBGX): "If they're looking for a super safe investment, it just might behoove them to stay in a shorter-end bond."

Levisohn is a staff editor at BusinessWeek covering finance and personal finance.

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