U.S. Treasury Bonds: Why the Safest Investment is Now One of the Riskiest
by Alexander Green, Chief Investment Strategist
Tuesday, June 1, 2010: Issue #1271
U.S. Treasury bonds are the safest investment in the world.
However, that doesn't mean they can't be dangerous. Far from it.
Yet a few days ago, The Wall Street Journal reported that, "Long-dated Treasury securities are now the most favored financial assets for global investors fleeing the eurozone's debt crisis."
Talk about jumping out of the frying pan and into the fire...
Don't get me wrong. I'm not one of those end-of-the-worlders who expect the U.S. government to default on its sovereign obligations. That won't happen.
It wouldn't even be necessary. After all, history shows that governments always prefer to inflate their way out of a debt crisis by cranking up the printing presses instead. That way they can achieve a de facto debt reduction simply by devaluing the currency.
If you've seen the photographs of German citizens hauling wheelbarrows full of cash into the bank during the days of the Weimar Republic, you know what I'm talking about.
Of course, I don't expect inflation like that. And neither should you.
But what kind of inflation does an investor expect who loans his money to the government for 30 years at a rate of just 4.1%?
Why U.S. Treasury Bonds Could Bulldoze Your Portfolio
That 4.1% figure is the current yield on the long end - and it's a bet that has a little upside potential and a whole world of downside risk. Why?
Imagine a seesaw with interest rates and inflation on one end and bond prices on the other. If inflation goes down, bond prices go up. And vice-versa.
But how far down can rates go on the long end? Unless we have the sort of deflationary environment that Japan suffered in the 1990s, the appreciation potential here is minimal.
On the other hand, if inflation rears its ugly head, long bonds will get clobbered. And the worse inflation gets, the worse these bonds will do.
I realize that inflation is not an immediate threat. Technology and deregulation have brought costs down over the past decade. And even oil prices have moderated lately.
But if the bond market gets even a whiff of higher inflation, these bonds will drop like a stone. And I'm betting that investors who weren't around during the early 1980s - and even many who were - don't realize it.
They are so busy patting themselves on the back for eliminating default risk - and picking up a 4% yield versus next-to-nothing on the short end - that they are forgetting about interest rate risk: the risk that higher inflation will send long yields soaring and bond prices crashing.
Don't Let the Government Trick You into Speculating
Seth Klarman, President of the Baupost Group, an investment firm in Boston that manages $22 billion, says the U.S. government is inadvertently provoking its citizens into taking very bad risks right now.
"By holding short-term interest rates near zero, the government is basically tricking the population into going long on just about every security except cash, at the price of almost certainly not getting an adequate return for the risks they are running. People can't stand earning 0% on their money, so the government is forcing everyone in the investing public to speculate."
Of course, most people aren't exactly in a speculating mood right now.
So what are they doing? They're buying super safe long-term Treasuries and earning over 4%.
Except that's not a safe investment - as many will eventually learn to their chagrin.