Treasuries Are Dead Money With Yields Below Inflation

Sept. 29 (Bloomberg) — The rally in U.S. Treasuries may be running out of steam after yields fell to the lowest since Franklin D. Roosevelt was president.

Renewed concern about the stability of the banking system sparked a run on Treasuries that drove bill rates down to 0.02 percent. Concern is so widespread that investors are buying 30- year bonds even though their yields are the furthest below inflation since at least 1980.

“It’s like the Mark Twain quote, `I am more concerned with the return of my money than the return on my money,”’ said James Evans, a senior vice president at New York-based Brown Brothers Harriman & Co. who helps oversee $15 billion in fixed- income assets.

The problem for bond investors now is that yields are at or below where economists and strategists expect them to end the year. The weighted average of 53 forecasts in a Bloomberg survey is for 10-year note yields to finish 2008 little changed from 3.85 percent last week, while two-year yields may rise to 2.33 percent as prices of the securities fall.

Ten-year notes yielded dropped to 3.71 percent and two-year rates to 1.88 percent as of 9:51 a.m. in New York, according to BGCantor Market Data.

Even if demand for government debt persists, keeping two- year yields where they were last week, investors would realize an annualized rate of return of only 2.1 percent. The consumer price index is rising at a 5.4 percent rate.

Bearish Sentiment

“The only reason to like Treasuries at this point is as a place to hide,” said Stewart Taylor, a senior trader who helps oversee $6 billion in investment-grade debt at Boston-based Eaton Vance Management. “The story of the Treasury market is you’re willing to accept less than the inflation rate, meaning you’re locking in losses, essentially.”

Investors are more bearish on Treasuries than anytime in the past three years. Jersey City, New Jersey-based Ried, Thunberg & Co.’s index measuring the sentiment of money managers overseeing $1.29 trillion toward 10-year notes tumbled to 40 in its Sept. 29 survey from 45 a week earlier. Readings below 50 indicate investors expect bonds to fall by year-end.

The index is the lowest since April 22, 2005. The following quarter, 10-year notes lost 2.24 percent, according to Merrill Lynch & Co.’s Treasury Master Index.

Wall Street Turmoil

Investors trying to call the top in Treasuries have been burned this year, as the collapse of Bear Stearns Cos. in March pushed 10-year yields down to 3.31 percent even as bond bears said rising oil and commodity prices would spark faster inflation. And at the start of August, fed funds futures on the Chicago Board of Trade suggested traders expected the Fed to raise interest rates by year-end. Now, bets are skewed to a cut.

The bankruptcy of Lehman Brothers Holdings Inc., the government’s takeover of insurer American International Group Inc., losses at money-market mutual funds and the failure of savings and loan Washington Mutual Inc. created unprecedented demand for all but the safest of government assets this month.

The U.S. House of Representatives today will debate a $700 billion plan backed by the Bush administration to revive the financial system. The House is expected to vote about noon Washington time today and then send the measure to the Senate.

Investors were so risk-averse in the past two weeks that they were willing to accept almost nothing in exchange for the assurance they’d get their principal back.

Money Market Guarantee

Three-month bill rates fell to 0.02 percent on Sept. 17, the lowest since reaching 0.01 percent in January 1940, four months after Adolf Hitler‘s invasion of Poland triggered the Second World War.

To revive confidence in the financial system, Treasury Secretary Henry Paulson on Sept. 19 announced a program to insure money-market funds for the next year along with a $700 billion plan to buy troubled mortgage and other assets from financial institutions.

The money-market guaranty program “doesn’t necessarily reverse the direction in terms of suddenly bringing a lot more confidence back into the system for investors who have no risk tolerance to begin with,” said Ajay Rajadyaksha, the head of fixed-income strategy in New York at Barclays Capital Inc.

Barclays is advising clients to bet on a rise in yields of longer-term debt such as 10- and 30-year bonds because the government is likely to sell more securities to finance Paulson’s bailout plan.

Thirty-Year Bonds

The Troubled Asset Relief Program, or TARP, would push funding needs to $1.5 trillion in 2009 and 2010, according to Merrill Lynch economists Drew Matus and David Rosenberg in New York.

“We’re certainly worried about supply,” said Eaton Vance’s Taylor. He said he would likely have taken a “significant” short position — a bet that Treasury prices would fall — if he judged the securities only against economic growth and trading patterns. Instead, Taylor owns Treasuries, just a smaller percentage than contained in the benchmark index he uses to measure performance.

Treasury 30-year bond yields are about 0.98 percentage point less than the rate of inflation. Since 1980, they have averaged 3.97 percentage points more than the rate of price increases.

In another sign that investors are putting safety above returns, two-year note yields have averaged 18 basis points below the Federal Reserve’s target rate for overnight loans between banks this year, compared with an average of 25 basis points above the rate over the last decade.

Just Wanting Treasuries

“I think we all understand that buying two-year notes below two percent is probably not a good long-term investment, but it’s just more safe haven buying than anything else,” said John Hendricks, a senior vice president at Hartford Investment Management in Hartford, Connecticut. “People just want to be in Treasuries right now.”

The $868.9 million Inflation Plus Fund Hendricks manages had 95 percent of its holdings in Treasury-Inflation Protected Securities as of June 30, according to the firm’s Web site, and outperformed 96 percent of its peers last year, according to Bloomberg data.

To contact the reporter on this story: Sandra Hernandez in New York at shernandez4@bloomberg.net

Last Updated: September 29, 2008 09:58 EDT

By Sandra Hernandez

Source: Bloomberg

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