With the Federal Reserve reiterating its stance on a low interest rate environment, falling bond yields have been a major investment theme so far this year. The benchmark 10-year U.S. Treasury yield, which went as high as 3.99 percent in April, sank to 2.62 percent in August. Lower income payouts have given bond investors plenty to complain about, but the decline in yields has led to a massive rally in bond prices. Is a major correction coming?
Government bond ETFs, especially ones with maturities longer than 10 years, have enjoyed the run by soaring to new heights. Among long-dated Treasury ETFs, the iShares Barclays 20+ Year Treasury Bond Fund (TLT) is up 22.28 percent, the Vanguard Extended Duration ETF (EDV) is ahead by 32.99 percent and the Direxion Daily 30-Year Treasury Bull 3x Shares (TMF) has soared 72.21 percent year-to-date (figures are through the Aug. 30 market close). Are more gains ahead or is the best over?
Despite talk of a debt bubble, yields on U.S. government Treasury bonds are in line with those in the developed world. The record lows on yields for Japanese government bonds (JGBs) are 0.5 percent on 10-year and 1.0 percent on 30-year debt. The yields of the JGBs are in the process of retesting those lows that were set in 2002 although Japan is carrying a national debt that is some 200 percent of its GDP.
Interestingly, China is buying up JGBs to diversify out of U.S. Treasuries. Low yields haven't discouraged creditors even while the Bank of Japan has been printing money to avoid losing its export edge.
Where do China and other creditors park their money elsewhere if not in U.S. Treasuries? Euro-denominated debts may be worse than U.S. Treasuries. The euro zone is still printing money in order to fight deflation, and the supplies of new money are increasing consistently. The U.S. is certainly in terribly bad financial shape; however most of the other developed nations are not any better.
Piling into Bonds
Over the past decade, the American public has participated in and experienced its fair share of financial bubbles. The meltdown in technology stocks along with the subsequent collapse of the housing market victimized millions. But instead of learning from these mistakes, people seem to repeat them.
The Investment Company Institute confirms this trend. Bond funds raked in $559 billion from January 2008 to June 2010 while over the same period stock funds had outflows of $232 billion. "I'm not a market-timer. However, based on new research that follows ETF cash flow, this is a very bullish sign for equities," notes Richard Ferri, CFA and president of Troy, Mich.-based Portfolio Solutions. Indeed crowd behavior is becoming more and more apparent in the bond market.
Treasury Credit Risk?
What about a government that racks up huge deficits, like the U.S.? This year's budget deficit is estimated to surpass $1.4 trillion, or 9.1 percent of GDP. According to the annual report by the Financial Management Service, a bureau of the U.S. Treasury, the government's entitlement programs such as Social Security and Medicare are facing a deficit over the next 75 years of $45.88 trillion. Would you want to lend money at today's rock bottom interest rates to a borrower facing these sorts of financial liabilities?
As the balance sheet of the U.S. gets weaker and economic problems persist, it would be reasonable to assume that creditors demand a higher yield. While this hasn't happened just yet, there are early warning signs that the times of cheap money for the U.S. government is over.
