Recession Priced Into Treasuries, as Yields Near Historic Lows

"In fact, the only time rates were lower than they are today was just before and just after World War II.  Rates on the 10-year Treasury bond have been lower less than 2% of the time going back to 1800," Burns wrote in an email, attaching a chart that shows 10-year bonds hovering around 2.00% just after the Great Depression of the 1930s as well as just after the post-Civil War period of the Long Depression at the turn of the last century (see chart).

Where will rates go from here?  Burns reckons that since that there is not a lot of room for rates to continue to drop, there are just two options: up or sideways. And by sideways, he means flat—for a long, long time.

"There is plenty of precedent for prolonged periods of low flat interest rates," Burns wrote. "Following the Long Depression (1871-79) and the Great Depression (1929-33), interest rates stayed low for decades as the economies of the time struggled to recover. The Federal Reserve Bank, last week, issued a statement that they would keep short-term rates low through at least mid-2013, adding to the likelihood of continued low rates.  Japan has seen interest rates below 2% since 1997, which will likely continue for the foreseeable future as they struggle to recover from recent natural disasters."

What should investors do? Burns said individual bonds are a better bet than bond funds, explaining that investors are extending further out on the yield curve to capture more yield. Doing so in a bond fund exposes investors to risk of loss when rates rise, he said.

"That's the Catch-22. Stay short and earn nothing, but protect against larger losses or extend out to earn higher yields and expose yourself to bigger losses when rates rise," Burns wrote. "Although it is hard to see it with yields so low, this market highlights the real advantage of individual bonds.  Investors can move out on the curve and pick up the greater yield, but if rates rise, they don't have to sell. Instead, they can simply hold the bonds to maturity and receive the YTM on the bond as the worst case. In fact, the individual bond is very predictable, which makes planning easier since worst case returns are known from the beginning and are positive."

For another look at how Treasuries are being poriced in, check out this article on the upcoming meeting of central bankers.

Read about the Fed's possible QE3 effect on treasuries at AdvisorOne.