By JASON ZWEIG
The "bond vigilantes" who once imposed law and order on financial markets are being run out of town. That means investors thirsting for a quick return to "normal" interest rates might stay parched for a long time to come.
Throughout most of the bull market in bonds over the past 30 years, big investors dumped Treasury securities whenever the U.S. flirted with fiscal recklessness. By sending a stinging signal to Washington that they wouldn't tolerate irresponsible policies, the vigilantes imposed discipline and kept rates stable at yields investors could live on.
But the bond vigilantes are on the run, warns Todd Petzel, chief investment officer at Offit Capital, a New York firm that manages $6 billion for wealthy clients. In recent years, Mr. Petzel says, the Treasury market has changed in profound ways.
Historically, the bulk of U.S. Treasury debt was held by private investors -- including the big institutions that used their enormous market power, vigilante-style, to keep interest rates in line.
Now, Mr. Petzel points out, much of the demand for U.S. debt comes from "uneconomic" buyers who scoop it up -- and hold on to it -- at any price. Only 23% of Treasurys are held by individual and institutional investors -- down from 55% in 1982 and 31% a decade ago.
Today, foreign holders -- largely central banks desperate to stabilize their currencies and banking systems -- own 34% of Treasury debt. That is up from 13% in 1982 and 18% a decade ago. The Federal Reserve, meanwhile, holds 11% of Treasurys, twice its share in 2008.
With so much demand from price-insensitive buyers, "Treasurys are priced like fire insurance gets priced after the buildings are already burning," says Dan Dektar, chief investment officer at Smith Breeden Associates, which manages $6.4 billion in bonds in Durham, N.C.
The conventional wisdom is that after another year or two, interest rates are bound to go up as investors penalize lawmakers for their profligate ways by demanding higher yields.
Don't be so sure, Mr. Petzel says. "The single biggest mistake that smart people have made over the past few years," he says, "is assuming that interest rates have to go up."
Instead, he warns, the yield drought might last not only until 2014, as the Fed is forecasting, but far beyond.
The market says Mr. Petzel is wrong. Derivatives traders expect short-term rates and the yield on the 10-year Treasury to rise by roughly 0.4 and 0.75 percentage points, respectively, by 2015 -- and by up to 1.5 points five years out.
But the market might not be fully recognizing another looming problem, Mr. Petzel says. Under the Dodd-Frank financial-overhaul law, the trading of many derivatives -- complex instruments like interest-rate swaps -- will eventually migrate to central "clearinghouses." Buyers and sellers will have to post "margin," or collateral, to back their positions.
One obvious choice for that margin would be U.S. Treasurys -- yet another form of the artificial demand for government debt that the economist Carmen Reinhart calls "financial repression."
Such derivatives total an estimated $700 trillion in "notional" or face value outstanding. If only 10% of the total is affected, with an initial requirement of even just 1% margin from both the buyers and the sellers, that implies an extra $1.4 trillion in demand for short-term Treasurys, reckons Mr. Petzel. Those new purchasers would have to buy the debt no matter how paltry its yield.
A derivatives trader at one of the world's largest hedge funds tells me that he finds Mr. Petzel's estimate "quite believable" -- if not conservative.
So what should investors do to survive a potential long march through a yield desert?
First, with so many new holders who aren't price-sensitive, Treasurys are more likely than ever to hold up in a crisis -- as they did in 2008 and 2009. Thus, even at today's measly yields, Treasurys still have a place as a hedge against a fall in your stock portfolio.
Next, recognize that if rates stay low for years on end, inflation will eat your cash alive. "So you should keep your cash component as small as possible," Mr. Petzel says.
When interest rates are low and stable, a Ginnie Mae or other high-quality mortgage fund should generate some extra income, Smith Breeden's Mr. Dektar says. The Vanguard GNMA
Investment-grade, intermediate municipal bonds are yielding 2.2% and up, or 3.4% after tax for upper-income investors.
Above all, grit your teeth and lower your expectations for higher yields. We might be stuck in the flatlands for a long while.—firstname.lastname@example.org; twitter.com/jasonzweigwsj