As Stocks Surge, US Treasurys Lose Their Appeal for Investors

By Jeff Cox
|  Monday, Jun 1, 2009  |  Updated 2:15 PM EDT
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As confidence increases in the stock market and a slew of other factors works against government debt, investors are unlikely to flock to Treasury bonds until yields get significantly higher.

The looming threat of inflation along with the tumble of the dollar and the unabated gush of government debt also are pushing bond prices lower, a move magnified Monday as stocks surged more than 2 percent and the price of Treasurys plunged.

That's a trend that has held especially true for longer-dated debt. But regardless of the term, investors are eschewing bonds, posing significant problems for a government struggling to finance its multiple stimulus and bailout efforts.

"The reality is the Fed is totally out of control here and it's causing all kinds of unintended consequences as a result or this monetization of US debt and the debasement of the US dollar," says Mike Larson, analyst at Weiss Research. "The market's going to extract it's pound of flesh somewhere--whether that's the currency market, the bond market, or if it's some sort of tag-team."

Both the dollar and longer-dated government bond prices have been taking a beating lately, the results of which have been on display during mostly tepid government auctions and in currency trading around the globe.

It is Treasurys, though, that prove particularly vexing for the government, which needs high demand to drive up prices and push down yields.

While the Fed has been more successful in that effort with the two-year Treasury, the trend elsewhere has been for lower prices and higher yields, particularly in the 10-year.

Investors closely watch the spreads between two-year and 10-year yields for clues as to the way interest rates trend for mortgages and other debt and what the economy has in store. A broad spread indicates both the threat of inflation and the prospect for economic growth, but some analysts worry that too much growth will push the inflation rate past the bond yield, meaning that investors will lose money in real terms by buying Treasurys.

Bill Gross, co-CEO of Pimco, the world's largest bond fund manager, said last week that 10-year Treasury yields will have to be in the 4 percent neighborhood to attract investors. Some portfolio managers say that could be on the low side.

"If they get up towards the 4 percent range, at least it's possible you can argue with a straight face that they don't represent a losing proposition in real terms," says Chip Hanlon, president of Delta Global Advisors in Huntington Beach, Calif. "Inflation is going to be a challenge and is probably underrated. It's going to become a really big problem given our policy course."

>>Live Quotes on US, London and German bonds here

Market experts say the current trends are likely to continue until the government reverses course and stops flooding the market with Treasurys while buying up agency debt such as mortgages underwritten by Fannie Mae and Freddie Mac.

In fact, some investment advisors are so concerned that they're using exchange-traded funds to short Treasurys.

Treasury bear funds are relatively new to the market and often trade in low volume, presenting dangers to less sophisticated investors. Yet they've come increasingly popular.

Some of the more active have been the ProShares UltraShort 20+ Year Treasury (AMEX: TBT) that pays for moves lower in the Lehman Brothers 20+ index; and the iShares Barclays Short Treasury Bond (NASDAQ: SHV), which pays for gains in the Barclays Short Treasury index.

The short ETFs provide a lower-risk way to give investment portfolios opportunity in the move lower in longer-term government bonds.

Larson says investors who feel a need to have government-issued securities in their portfolios can explore other avenues, such as some of the bonds of foreign governments. There are ETFs to track those movements as well.

Some of those funds include the SPDR Barclays International Treasury Bond ETF (NASDAQ: BWZ) and the iShares S&P/Citi 1-3 Year International Treasury Bond (NASDAQ: ISHG).

With the various other forms of government-backed debt on the market that provide better yield than Treasurys, now seems not to be the time to be in long-dated government bonds.

"There's just so much supply of them that I really wouldn't own them," says Michael Cohn, chief investment strategist at Atlantis Asset Management in New York and holder of the UltraShort 20+ Treasury ETF. "There's plenty of other things out there that are basically government guaranteed that have much better yield. I wouldn't go after generic US government Treasury bonds at all."

In fact, Cohn goes beyond Gross' sentiment that Treasurys yields will need to hit 4 percent--he thinks the number could be closer to 4.75 to 5 percent to get retail investors back into bonds.

Without a major shift in policy bond prices are likely to remain low, he says.

"The government's between a rock and a hard place," he says. "The day that they announce that they're going to scale back their purchases of all this stuff they're supporting to keep housing interest rates low, it's going to be this ridiculous rush to the exits on government bonds. I would rather be on the other side of that."

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