Unlike most asset classes, Treasury bonds had an excellent year in 2011. Whereas domestic equities were essentially flat for the year, Treasuries saw an almost ten percent return, benefiting greatly from the flight to safety that has taken place since the 2008 credit crisis.
After the near-collapse of the financial system during that fateful summer in 2008, the stock market tanked, and the economy sunk into a recession. With investors suffering from terrible losses, they looked for any place where they would be guaranteed security of principal. As it turned out, that place was U.S. Treasury bonds.
Over the past three years, investors have been plowing money into government debt, bringing down interest rates to levels never seen before. Short-term Treasury bills are yielding essentially zero percent interest, which means that investors are willing to give the government free money just for the security of knowing that their principal is safe. Even long-term 30-year Treasury bonds are currently yielding less than three percent.
The Case Against Bonds
Given the dramatic increase in Treasury prices over the past several years, many famous institutional investors decided to make big bets against the bull market in government bonds, reasoning that rates could not possibly go any lower. Indeed, some analysts were beginning to think that government bonds were exhibiting a bubble much like the real estate market before 2007 or technology stocks before 2000.
They argued that in the rush to buy safe assets, many investors were ignoring the risks of future inflation, which tends to erode the value of nominal bonds like Treasuries. The Federal Reserve has been doing everything possible to resuscitate a moribund economy, including two rounds of quantitative easing. Thanks to the massive increase in the money supply, some have speculated that inflation could prove to be an increasingly serious problem in the future if demand ever rebounds to its previous levels.
In addition, many believe that massive increases in borrowing by the U.S. government could lead to higher interest rates in the future as their increased demand for money crowds out other private borrowers who seek funds. In 2011, the United States ran a budget deficit of more than eight percent of GDP; in addition, there does not seem to be any reasonable expectation for that deficit to be eliminated in the next decade, especially considering the increasing burden that the baby boomers will place on entitlement programs like Social Security and Medicare.
The Bond Market Beats the Experts
Many high-profile investors have made big bets against Treasury bonds using similar reasoning. Consider, for instance, the story of Bill Gross, the legendary head of the PIMCO Total Return Fund. In early 2011, Gross sold all of his Treasury holdings, arguing that yields were far too low to be attractive to bond investors.
However, despite all of his expectations, the yields on Treasury bonds continued to fall throughout the year. Eventually Gross threw in the towel and started to repurchase Treasury bonds; unfortunately for his investors, they were left scratching their heads with their poor investment returns, which lagged the Barclays Capital U.S. Aggregate Bond Index by more than three percent.
Now Gross, like many fellow bond investors, is counting on the Federal Reserve to maintain its commitment to keep interest rates at low levels at least until the middle of 2013. By making such a commitment, the Federal Reserve is hoping to encourage consumers and businesses to borrow more money to stimulate the economy, something they have been rather reluctant to do as of yet.
The Cloudy Future of Bond Yields
As for the future of Treasury bond prices, the picture is far from clear. Commonsense would seem to dictate that prices have nowhere to go but down; however, many investors like Gross have been burned with very similar thinking. As long as the economic recovery remains weak, the Federal Reserve will continue to keep interest rates down, and Treasury prices will therefore remain at high levels.
However, for those investors who are seriously worried about the future direction of interest rates, there are some ways to mitigate the risks of falling bond prices to a portfolio. One way to do this would be to invest in more short-term Treasury bills, which have maturities of less than a year. These government bonds are less sensitive to long-term interest rates since they can be quickly rolled over into new debt issues when they reach maturity.
In addition, for those investors who are very worried about future inflation, Treasury Inflation-Protected Securities, better known as TIPS, can essentially eliminate that risk. TIPS are tied to the Consumer Price Index, ensuring that your principal and interest payments keeps up with inflation.
Regardless of one’s opinion as to the future of interest rates, both Treasury bonds and TIPS can serve a useful role in a diversified portfolio. Thanks to their low risk and less-than-perfect correlation with stocks, government debt can help to reduce the overall volatility of a portfolio. Many financial experts say that investors should allocate a percentage of their portfolio to bonds equal to their age, but investors should ultimately make their own decisions concerning a proper asset allocation strategy. Regardless U.S. government debt provides long-term safety to investors, an invaluable trait in these uncertain economic times, and most investors would be well-served to allocation at least a small portion of their portfolio to them.
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