The Bear Market in Treasuries Will Worsen

THE BUBBLE HAS BURST.

We're talking about U.S. Treasury securities, not housing. At the end of 2008, risk-averse investors poured into Treasuries, driving down yields to the lowest levels in decades. The 30-year Treasury bond fetched less than 3%, and short-term T-bills carried yields of zero.

Since then, the economy has shown signs of bottoming, the credit markets are functioning more normally, and the stock market has roared back from its March lows. Treasuries now are in a bear market, while bullish enthusiasm has taken hold in other parts of the credit market, including corporate bonds, municipals and mortgage securities, all of which had fallen from favor late last year. The 30-year Treasury, for instance, has risen to a yield of 4.10% from 2.82% at the end of 2008, cutting its price by 20%.

Barron's called a top in Treasuries and a bottom in the rest of the bond market in an early 2009 cover story ("Get Out Now!" Jan. 5). We weren't alone in recognizing some of the nutty year-end developments. Warren Buffett highlighted the sale in late 2008 by his Berkshire Hathaway of a Treasury bill for a negative yield. Buffett wrote in Berkshire's annual letter in February that when "the financial history of this decade is written...the Treasury-bond bubble of late 2008" may rank up there with the housing bubble of the early to middle part of the decade. - How does the market look now? Treasuries still look unappealing for several reasons. Yields are very low by historical standards, the government is issuing huge amounts of debt to fund record budget deficits, and the massive federal stimulus program ultimately may lead to much higher inflation.

"There are better values elsewhere among high-quality bonds," says Steve Rodosky, an executive vice president at Pimco, which runs the giant Pimco Total Return fund (PTTAX), the country's largest bond fund; it's besting its peers again this year, with a 4.8% return so far in 2009. Pimco's chief investment officer, Mohamed El-Erian, was blunt at year's end, saying, "Get out of Treasuries. They're very, very expensive."

While holders of Treasuries ultimately will get their money back, prices could fall sharply in the interim, and repayment could be in greatly depreciated dollars. Treasury yields may rise further in the coming year, meaning that prices will fall as the economy strengthens. The yield on the 30-year bond could top 5% and the 10-year note could rise to more than 4%, from a current 3.15%.

IF THE BOND-MARKET THEME of 2008 was a flight to quality, this year it has been flight from quality, as lower-grade, more speculative securities generally have generated the best returns. Returns on junk debt and lower-grade municipals have topped 20%, while the rise in government-bond yields has become a full-blown global phenomenon.

Even after rallying in recent months, the corporate-bond market looks attractive (please see story, "Corporate Bonds Are Back"). The average junk bond in the Merrill Lynch high-yield index has fallen to a still-lofty 15% yield, from 19.5% at year's end, while more highly rated corporates -- those with triple-B ratings -- yield around 8%, a comfortable four percentage points above long-term Treasury rates.

The municipal-bond market also has advanced in 2009, with the yield on top-grade long-term securities falling to about 4.5%, from 5.25%, while rates on lower-rated securities like tobacco-revenue bonds and hospital debt, which topped 10% at year's end, have dropped more than a percentage point.

High-grade, 30-year munis now look reasonable. At the end of last year, top-grade 30-year munis carried double the yields of 30-year Treasuries, an off-the-charts relationship. Now, the 4.5% yield on triple-A-rated long-term bonds is slightly higher than the yield on the 30-year Treasury.

That spread remains generous by historical standards. It is hard to get too enthusiastic about intermediate-term bonds with maturities of less than 10 years; they're yielding 3% or less. Lower-grade munis could have more room to run.

The muni market could benefit if President Barack Obama succeeds in lifting the top marginal income-tax rate to 39.6% from the current 35%, because that would boost the appeal of tax-exempt interest income. State and local finances, however, are a mess throughout the country -- particularly in California -- due to a weak economy and the unwillingness of politicians to tackle the ballooning cost of pensions and health care for government workers.

It's a tale of two markets in the mortgage-backed sector. There isn't much appeal in government-backed Ginnie Maes -- or in Freddie Mac and Fannie Mae securities, which carry an implicit federal backing. These securities yield just 4%. That means funds like the big Vanguard GNMA (VFIIX), now carrying a 4.3% yield, could have disappointing returns.

The riskier -- and more attractive -- part of the market is the so-called non-agency sector of home- and commercial-mortgage securities. These yields still can top 10%. Funds with exposure to the non-agency mortgage market include TCW Total Return (TGMNX), which has a current yield of 10%.