Risk of loss on Treasuries "quite substantial’

The risk of owning U.S. government debt is as great as at any time since the 1950s, with yields at the year's lows and Treasury Secretary Timothy Geithner locking in borrowing costs by selling longer-term securities.

Yields on Treasuries would need to rise only 0.3 percentage points over one year on average, from 1.67%, to produce a loss, based on the benchmark Barclays Treasury Index, according to a study by First Pacific Advisors LLC. The last time that bonds were close to this level was in March 2009, when a 0.43-percentage-point rise in yields would have left holders of comparable-maturity five-year Treasuries with losses.

“You have to go back into the 1950s to find this kind of activity,” said Thomas Atteberry, who manages $3.7 billion in fixed-income assets at First Pacific.

“Interest rate risk is the most acute it's been in an extremely long time. I have to stay short, five years and in,” Mr. Atteberry said.

By shifting more of the risk of higher interest rates onto investors as it increases the average maturity of U.S. debt, the Treasury risks dampening demand at bond auctions needed to finance the government's $1.3 trillion budget deficit. The average due date of the $9.1 trillion of marketable debt outstanding rose to 60 months in March, from a 24-year low of 49 months in 2008.

“For new money that comes in today, there isn't much of a cushion,” said James Sarni, senior managing partner at Payden & Rygel, which manages $50 billion. “The risk of losing money is, I believe, quite substantial.”

WEAK ECONOMIC DATA

Bonds rallied this month as reports showed that manufacturing last month expanded at the slowest pace in 20 months, unemployment rose to 9.1% and consumer confidence fell to a six-month low.

The yield on the benchmark five-year note was little changed at 1.59% last week, after falling 0.12 percentage points the week before. The price of the 1.75% security due in May 2016 rose 18/32 in the five-day period through June 3, or $5.63 per $1,000 face amount, to 100 23/32, Bloomberg Bond Trader prices show.

Ten-year yields reached 2.94% on June 1, the lowest since Dec. 6.

The median estimate of 70 economists and strategists surveyed by Bloomberg News is for the 10-year yield to rise to 3.8% by year-end. Investors in the security would lose 4.63%, Bloomberg data show, be-cause prices of bonds with longer maturities typically are more vulnerable to movements in interest rates.

“SWEET SPOT’

Allstate Corp., which manages $80.2 billion in fixed-income assets, and Loews Corp.'s CNA Financial Corp. unit, which oversees $38 billion in bonds, said that they are shifting to intermediate maturities, given the risk to the principal of longer-term securities.

“What we're focused on is maintaining yields in the portfolio and optimizing interest rate risk,” Judy Greffin, Allstate's chief investment officer, said during a June 1 conference call with analysts.

Medium-term bonds are “basically the sweet spot for us,” James Tisch, chief executive of Loews, said June 3 at a conference in New York. “It provides us protection in case interest rates continue to decline, but likewise if interest rates rise, it provides us a steady cash flow of both cash and maturing investments so we can then reinvest at the higher rates.”

Of the $2.249 trillion of notes and bonds sold by the Treasury last year, 38%, or $851 billion, were of maturities of more than five years, compared with 25%, or $231 billion of the $922 billion sold in 2008. Demand has increased as sales have continued at a near-record pace.

The Treasury has received $3 in bids for every dollar auctioned this year, compared with last year's record $2.99, government data show. The United States has sold $895 billion of notes and bonds so far this year, versus $1.003 trillion at the same point a year earlier.

Yields on 10-year notes are 2.2 percentage points below the average over the past 20 years and about half the average since 1953, during the Eisenhower administration.

EISENHOWER RECESSIONS

The president then grappled with an economy that fell into a 10-month recession in 1953, an eight-month contraction in 1957 and another 10-month slowdown in 1960. The yield remained below 3% from the third quarter of 1953 through the second quarter of 1956, and dipped below that level again in 1958.

Bond yields began a 20-year climb after the end of the last Eisenhower recession in 1961, reaching a peak at 15.8% in 1981 as Fed Chairman Paul Volcker raised the central bank's target rate for overnight loans between banks to 20%, to contain surging inflation.

While the risk of holding bonds may be the same as the 1950s, new financial products derived from Treasuries may raise the danger level, according to David Jones, former vice chairman of Aubrey G. Lanston & Co. Inc. The firm was one of the original primary dealers that are obligated to bid at Treasury auctions.

“We now have a Treasury bond market that is global, and we have so many different categories of debt and derivatives that you can almost make no comparison,” Mr. Jones said. “It lends a lot of volatility to the Treasury yield we never had before, when it was a much more domestically focused market.”

This year's rally led James Kochan, who helps manage $231 billion as chief fixed-income strategist at Wells Fargo Funds Management LLC, to stop advocating the purchase of long-term U.S. government debt. Yields on Treasuries due in 10 years or sooner are less than the 3.2% increase in the consumer price index in the 12-month period ended April 30.

“You've got a lot more risk in this market now,” Mr. Kochan said. “If I had to own Treasuries here, I'd be coming in on the curve,” buying shorter-term notes, he said. “This rally's overdone.”

Yields have declined as government and private measures of economic growth have fallen below economists' forecasts, boosting speculation that inflation may slow and make bonds more valuable.

The Institute for Supply Management said June 1 that its factory index plunged to 53.5 in May, from 60.4 the prior month. A day earlier, The Conference Board Inc.'s confidence index dropped to 60.8, from a revised 66 in April.

Employers added a fewer-than-projected 54,000 jobs last month, the Labor Department said June 3. The median forecast in a Bloomberg News survey called for payrolls to rise by 165,000.

Even with the economy slowing, the potential for losses on Treasuries is too great to make the securities attractive, according to David Brownlee, head of fixed income at Sentinel Asset Management Inc., which manages $28 billion.

“We've been liquidating Treasuries,” he said. “It's not that we hate them as an asset class, but we've been looking at more short-term mortgage-backed securities.”

“CLOSE TO A FLOOR’

Treasuries have returned 2.85% on average this year, including reinvested interest, according to Bank of America Merrill Lynch index data. Mortgage securities returned 3% on average.

The rally is dependent on the economy's falling back into recession, said Krishna Memani, director of fixed income at OppenheimerFunds Inc., who helps manage $70 billion.

If the market gets improving data in the United States and signs of stabilization in Japan and Europe, “I can see rates rising 50 to 60 basis points fairly quickly,” he said. “We are getting quite close to a floor in Treasury yields.”