Treasury Funds: Get These Time Bombs Out of Your Portfolio
by Alexander Green, Chief Investment Strategist
Monday, June 21, 2010: Issue #1285
Tens of millions of investors have a ticking time bomb in their fixed-income portfolios.
Are you one of them? If so, there’s still time to defuse it.
A few weeks ago, I wrote an Investment U column entitled, “Why the Safest Investment is Now One of the Riskiest.”
I noted that investors – frustrated by the microscopic yields on money market funds and certificates of deposit (CDs) – have poured money into longer-term Treasury funds.
Their thinking is simple. Too simple: “These funds yield over 5%, not bad in this environment, and the bonds they hold are guaranteed by the full faith and credit of Uncle Sam. What’s to worry about?”
Plenty…
Aren’t Treasury Funds Free of Risk?
Unlike individuals, corporations, and municipalities, the federal government can simply create money to meet any obligations. U.S. Treasuries are thus free of credit risk. But they aren’t free of interest-rate risk.
When interest rates go up, Treasury bond prices go down. Yet investors are comforting themselves that inflation isn’t currently a problem and that long-term rates remain near historic lows.
Don’t be fooled. There is a monster on the horizon – and he makes Beowulf’s Grindel look like Barney.
- Over the past 18 months, the federal debt has surged from $5.5 trillion to more than $8.6 trillion.
- Two years ago, it was 38% of GDP. Today, it’s 59% of GDP. And by the Congressional Budget Office’s own estimates, it’s going much higher still.
This is dangerous. Yet inflation has remained remarkably subdued so far. But understand that if the government opts to stimulate the economy further – especially if some emergency action is needed – short-term rates are already at zero.
Having already thrown the kitchen sink at the slowdown from a monetary standpoint, the federal government will almost certainly opt to spend even more dramatically.
The bond markets will not take this news well. Long-term rates are likely to spike. And when they do, it will get real ugly, real quick.
Investors always think they have time to move out of longer obligations before that happens. But that is not likely to be true…
The Triple Threat to Treasury Funds
Between early October 1979 and late February 1980, for example, the yield on the 10-year note rose almost four percentage points, driving a stake through most people’s bond portfolios.
Making matters worse, millions of Mom-and-Pop investors have unwittingly plunged into leveraged bond funds in recent years, often on their brokers’ recommendation.
Leveraged bond funds borrow money in the short-term to buy more longer-dated issues and enhance the funds’ yields. This is all well and good when rates are flat to lower. But when rates spike higher, look out below. The same thing will happen to these funds as to a margined stock portfolio in a correction. |
In fact, leveraged closed-end bond fund investors could get hit with a triple-whammy…
- The bonds in the fund will drop when interest rates rise.
- The drop will be compounded by the fact that the portfolio is leveraged.
- The fund could plunge to a deep discount to its net asset value, too.
Become a Bomb Disposal Expert… On Your Portfolio
Not pretty. So what to do?
- First, check to see what percentage of your portfolio is in long-term bonds. It shouldn’t be more than 10% as a maximum (as protection against a deflationary scenario).
- Second, visit www.etfconnect.com and type in the symbols for your fixed-income ETFs or closed-end funds.
Then look at the number beside the fund’s “effective leverage.” Zero means the fund is unleveraged. But some may be leveraged up to 40% or more. (That’s how these funds are able to yield more than the bonds they invest in, even after expenses.)
In sum, this is a time to pare back your long-term bond holdings and eliminate most of your leveraged holdings.
Don’t take these words lightly. There is danger on the horizon. But if you act now, there’s still time to get that ticking time bomb out of your portfolio.
Good investing,
Alexander Green
Any investment contains risk. Please see our disclaimer.
18 Responses to “Treasury Funds: Get These Time Bombs Out of Your Portfolio”
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Does this mean we should reduce our holdings in THE PERPETUAL INCOME PORTFOLIO? Most of them are closed in funds.
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How do ‘zero-coupon’ bonds stack up in this scenario? Would they be considered as toxic as standard long term Treasury bonds?
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Alex, good article, but how does your point impact the perpetual income portfolio? Thanks
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The Perpetual Income Portfolio does not recommend Treasury funds and therefore these comments would not apply. High-yield bonds are more sensitive to the credit-worthiness of the issuer than interest rates.
Investment U
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Alex,
Very good article to the point and explained very well..The one question I have is how likely is it that the US economy experiences a Japanese type recovery/economy low interest rates for 10+ years with deflation..If the later scenario plays out, then no interest risk to your bond portfloio…What is your view on muni closed end funds that are insured? Same, time to pare back?
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Why is the article referring to the federal debt of $8.6 trillion and not the total gross debt of over $13 trillion?
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Does this apply to Build America Bonds, which are long term municipal bonds?
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I entered the following symbols and they all came up invalid: TIP, LQD, BWX, and BND. Thoughts?
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Does this affect our Inflation Protected Securities in our Vanguard “Gone Fishing” stocks? Please address this. Thank you.
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How does this advice on bonds affect my Perpetual Income Portfolio?
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Does this scenario mean my long term Municipal bond holdings are also at risk?
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This is a great piece of advice. Still working and contirubitng to a 401-K. The menu is of course limited, so is is imperative to be able to deduce quality by an independent means. This will be simple but oh, so powerful.
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How does Corporate and Junk bonds compare with this scenario?
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Alex,
In light of your warnings about bonds, maybe you could address the bond danger for the closed end funds in the Perpetual Income Portfolio. Looking at ZTR on cefconnect.com shows it is heavy in U. S. treasury bonds.
Thanks,
Larry
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Grendel, not “Grindel”.
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In response to your comment on the Perpetual Portfolio, EFR is leveraged at 37%! You have this symbol in two portfolios. According to your article, I should be scaling back but your comment says the comment does not apply….Consider me confused and please, follow up with a more reasonable explanation of leverage! Thanks.
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I would appreciate a review of the contents of the Oxford Club portfolios in this regard. Are we holding funds that should be dropped?
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How does this bond warning affect the fund by Pimco PTTDX? My mother owns this and it has done very well since she bought it in October 2009. She will sell it if I tell her to. Thanks!
Dana in Florida
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