Treasury bull creates historic buying opportunity

There is one bull market these days — U.S. government treasuries are experiencing a historic appreciation. Despite low yields, investors continue to pile into U.S. treasuries, creating what many managers say is the once-in-a-lifetime opportunity to be investing in bonds.

David Rosenberg, chief North American economist for Merrill Lynch, noted in a report released Monday that November was the best month for U.S. Treasury bill appreciation in almost three decades. In fact, investor preference for treasuries is so pronounced right now, Rosenberg speculates that it could be creating the next great asset price bubble.

“The total return generated by the Treasury market was +5.1% in November, making this the best month since 1981, when the yield on the 10-year note was 15%. Imagine that a coupon one-fifth that much can generate similar returns when the capital gain is factored in, even at microscopic interest rate levels. The Treasury market managed to return more in just one month than the U.S. equity market has managed to muster over the past decade,” he writes.

Rosenberg doesn’t see the asset price of treasuries declining; in fact, he postulates treasury yields could be heading to the April 1954 levels of 2.4%. However, the real opportunity for investors is not to ride the treasury craze to its peak but, rather, to take advantage of unprecedented spreads between other safe, albeit less liquid, bonds.

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Scott Lamont, head of fixed income for Phillips, Hager & North (PH&N), says growing fears about global deflation and a preference for liquidity have created the huge drive to treasuries. It’s also created a mass exodus from less liquid quality bonds.

“The (Federal Reserve) recently had a three-year treasury auction that actually went extremely poorly. The yields at that time were above 3.4%, but they have rallied 100 basis points in the span of two weeks. Really what that’s reflective of is the market’s embrace of deflationary psychology,” Lamont says.

This deflationary fear is paired with an immediate need for liquidity as investors rebalance their portfolios.

“Any time you’re in a financial crisis, liquidity becomes more important to people. As volatility goes up, people prefer more liquid securities. They want more liquid securities so they can change the mix of their portfolio,” Lamont says. “Everything with less liquidity starts acting the same way. That’s why a lot of risk models stop working in financial crises. Securities that have less correlation suddenly become a lot more correlated because liquidity starts to be the driving factor as opposed to security-specific issues.”

Some of the bonds that have been devalued remain some of the safest around, Lamont notes.

“If you don’t need to access liquidity, it’s about as good a time as you can get to capture some extra return,” he says. “Anything with less liquidity than treasury bonds or Canada bonds is trading at extremely attractive levels. You can buy 10-year provincial bonds today at close to 135 basis points over Canada bonds — that’s pretty compelling. A five-year Royal Bank bond you can pick up in excess of three full percentage points over a five-year Canada Savings Bond. These are securities where you truly have a low risk.”

Heather McOuatt, vice-president and portfolio manager with Bissett Investment Management, puts it even more succinctly.

“There is a pretty good risk/reward trade-off for buying corporate bonds. Quite frankly, I feel (it would be) unusual if we see this type of significant event again in our lifetime,” she says.

McOuatt says she’s positioning the funds she manages — the Bissett Bond Fund and Bissett Corporate Bond Fund — to benefit from a projected run-up in non-sovereign issues. If spreads start to come down between corporate bonds and treasuries, the asset price returns will be significant.

“We have been overweight in credit bonds — that is, agencies like Canada Housing Trust — as well as provincials and high-quality bonds. We are seeing really significant value in corporate bonds at this point. Right now a 10-year Canada Savings Bond is yielding about 3.25%, while a mid-term spread on corporate [above that] is about 3.60%,” she notes.

Rosenberg hypothesizes that the non-sovereign bond sector will likely be given a helping hand by the Federal Reserve, which seems to be positioning itself to buy a lot of these assets. This would give a de facto Fed guarantee on high-quality corporate and credit bonds.

“(Federal Reserve chairman) Ben Bernanke’s past musings suggest that he will be working with fiscal policymakers by being the captive market for the new debt issuance. He is also taking early steps toward quantitative easing by buying commercial paper, government-sponsored enterprise debt (GSE), GSE-backed mortgage-backed securities (MBS) and AAA-rated asset-backed securities,” he writes. “Looking ahead, there now seems to be greater risk–reward in high-quality spread product, especially since the Fed is becoming a direct buyer. So, asset-backed bonds, municipal bonds, bank bonds (now guaranteed by the government), GSE debt, Baa(-rated) corporates would seem to make sense, allowing for the fact that there still may be liquidity problems to consider over the near term.”

Lamont stresses that all of this points toward a need for investors to be looking at maintaining a strong diversified fixed income presence within their portfolio.

“In a portfolio context, it may still be appropriate to hold bonds, depending on the individual situation. This last number of months have been reflective of the fact portfolio diversification is a good thing. Even with yields as low as they are, Treasury bonds have been able to provide stability to portfolios, given all the volatility in the other asset classes,” he says. “There are areas of the bond market that still represent much better value in our view than treasuries.”

(12/01/08)