U.S. Treasuries Bubble?

The New York Times - March 22, 2009

The Way We Live Now
No Safety in Numbers
By ROGER LOWENSTEIN

Is there such a thing left as a safe investment? Stocks have been massacred, real estate all but wiped out. Each was promoted in its day — as was gold — as safe and secure, appropriate for widows and orphans.

If there is a truly last bastion of safety, it would be, of course, the U.S. Treasury bond, that venerable instrument with the full faith and credit of the United States behind it. Perhaps it is esteemed so highly because we think of it not as an “investment” per se but as an article of faith in Washington and, by extension, the entire country. It is our tax dollars, after all, that stand behind it — the accumulated output of our citizens. And ever since the Wall Street meltdown, as investors have fled from any security carrying a whiff of danger, Treasuries have been in hot demand.

So it is an eye-opener, and rather depressing, to report that even Treasuries bear risk, in particular, the risk that flows from crowd psychology. Last month, in his annual letter to shareholders (of which I am one), Warren Buffett wrote: “When the financial history of this decade is written, it will surely speak of the Internet bubble of the late 1990s and the housing bubble of the early 2000s. But the U.S. Treasury bond bubble of late 2008 may be regarded as almost equally extraordinary.”

Pretty strong words for an investment that has outperformed stocks over the past 25 years and is widely referred to as “riskless.” Yet according to Buffett and other investors of a cautious bent, “risk free” Treasuries of longer maturities are anything but. None other than China’s prime minister, Wen Jiabao, expressed worry about the safety of China’s big stake in U.S. bonds.

Not since World War II has the government borrowed anything close to what it is borrowing now. Because of the economic slowdown, the stimulus package and various financial-relief measures, pundits estimate this year’s federal deficit at $1.75 trillion. To put the figures in (alarming) perspective, over the past half century and regardless of the party in power, federal tax receipts have usually provided 80 to 90 percent of the money needed to fill the budget; thus, the government has had to borrow only the remaining fraction. But this year, it will need to borrow 45 percent, virtually half, of what it is projected to spend. This means that the U.S. government is looking much like a homeowner at the tail end of the boom: too hooked on spending (even if, hopefully, for a worthy cause) to stay within its means.

When you buy a Treasury security, you are actually lending the government money for a set period of time — from 30 days to 30 years — at a fixed rate of interest. Few people worry that Uncle Sam will go the way of a defaulting subprime borrower because the government, unlike other debtors, can always print the money it needs.

But as James Bianco, who runs an eponymous bond-research firm, explains, investors in fixed-income securities face two types of risk. One is ­credit risk — the risk of default. The other is what bond geeks refer to as “duration” risk. This is the risk that, even if the bonds are paid in full, the promised rate of interest will turn out to be worth less over time.

Inflation destroys bond values. It’s not a big deal over one or two years, but if you hold a long-term bond and inflation takes off, the present value of the security will plummet. Bonds also lose value as interest rates go up. If rates on 30-year U.S. bonds, recently 3 percent, were to rise to, say, 6 percent, the value of bonds issued at the lower rate would fall nearly in half. (The reason is largely intuitive: if the market rate is 6 percent, nobody would be interested in a 3 percent bond, and its price would fall.)

One thing that could make interest rates rise would be an economic recovery that spurred more firms to seek credit. That would be good news for the country, of course, but not for long-term bondholders. And it’s conceivable that rates on Treasuries could rise even without a strong recovery. Government budget deficits always bring a fear of higher rates (interest rates represent the price of credit, and deficits mean that the government will be demanding more of it). And given the looming shortfalls in Social Security and Medicare, it is not clear when the deficits will end.

Granted, Treasury bonds are not quite tulip bulbs or dot-com stocks. Investors purchase them out of fear, not greed. Presumably they are not doubling-down, buying Treasuries with borrowed money to juice profits. But that distinction may not save them.

Think of the yield on Treasuries as a reverse indicator of investor sentiment. The stronger the attachment people have for Treasuries, the more willing they are to accept a low return. Once the Wall Street crisis hit, investors traded what had been a strong attachment to Treasuries for downright love. Naturally enough, given this fearful ardor, the yield touched post-Depression lows.

As with any investment, generalized enthusiasm leads to frothy prices. In seeking safety, global investors pushed Treasuries to a vulnerable level. Bond-market optimists take comfort from the Federal Reserve Board, which has hinted that to keep interest rates from rising, it would be the lender of last resort. But were the Fed to absorb surplus Treasuries, the government would, in fact, merely be “printing money,” says Mohamed El-Erian, chief executive of the bond house Pimco. When the economy rebounds, such a scenario could lead to a textbook case of inflation and devastate the ultimate “safe” investment. And lately, bond rates have begun to rise.

The primary lesson of this crisis is that we, as a nation, took on too much risk — leveraging finite capital on a fantasy that no bet would ever go bad. But there’s another lesson, too. Even safety has its price, and if we overpay for it, we create new risks. Risk, in short, may be something we have to live with.

Roger Lowenstein, an outside director of the Sequoia Fund, is a contributing writer for the magazine.

Stocks could be more attractive than treasuries now.