The Perils of T-Bonds

Bond wizards, among them Pimco luminary Bill Gross, keep warning that prices of long-term Treasury bonds may crash should yields rise sharply. Yet those yields appear to be in a safety zone, stubbornly remaining near 4% despite an inflation rate of about 5% and massive government deficits. Buy long-term Treasury debt today and you're guaranteeing a loss of purchasing power, even before taxes. Worse, you're vulnerable to a significant loss of principal if yields rise to a more rational level and you have to sell your bonds before they mature. Bond-fund shares would also plunge.

Remember, Uncle Sam's "full faith and credit" refers to the timely payment of interest and eventual repayment of principal. It does not apply to the market value of U.S. bonds, which fall when interest rates rise and are as vulnerable to corrections as stocks are. The damage from falling Treasury prices can be a shock for investors who think government bonds are "safe" prior to maturity. In 1994, for example, yields on ten-year Treasuries surged from 5.6% in January to 7.4% in May. As a result, the bonds lost 12% of their value. From October 1998 to January 2000, the yield on the ten-year Treasury rose from 4.2% to 6.8%, resulting in an 18% price decline.

Foreign aid. So why aren't Treasuries tanking? The weakness of the U.S. economy is the usual explanation. But yields were low before the downturn, so that's not the whole story. Economist Brad Setser, of the Council on Foreign Relations, argues that those billions of dollars leaving the country to buy expensive oil -- a cost that's boosting the inflation rate -- are promptly recycled into Treasuries. Retired Wall Street bond analyst John Jansen says that investors such as the central bank of Kuwait trust only "a huge, liquid market" -- which the Treasury market certainly is -- even if it means settling for lower yields than are available from other kinds of investments.

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But your priorities differ from those of foreign governments. If you lose value on paper, you may not be able to wait ten or 20 years for the bond to mature and repay you the full value. And when inflation and taxes erode your investment, you can't sell oil or print money.

Risks at home. At some point, foreign investors and others motivated by fear will be unable or unwilling to prop up Treasury prices. In July, the U.S. government, its debt soaring, announced a massive increase in borrowing for 2009. In theory, that should lead to higher yields. "The government's balance sheet already looks like that of a junk-bond issuer," says Haag Sherman, chief investment officer for Salient Partners, a Houston investment manager. Simply put, he says, long-term Treasuries are "a bad deal."

That could be an understatement. Any economic upturn -- or just the hint of one -- will give the Federal Reserve Board room to begin raising short-term rates to battle inflation. In past tightening cycles, the Fed has boosted short-term rates about three percentage points, sending yields on short-term Treasuries up accordingly. Long-term Treasury bonds normally yield three percentage points more than Treasury bills (the term for three- to six-month debt often found in money-market funds), which are now yielding 1.7% to 1.9%. If bills reach 4.5%, the yield on the ten-year Treasury could rise to 7% or beyond. That would deliver a crushing blow to bondholders. The lesson is clear: For now, keep your risk under control by keeping your maturities short.

3 Strikes Against Treasuries

1. INFLATION. With inflation running at an annual rate of 5% and yields below that, Treasuries are losers -- guaranteed.

2. BUDGET DEFICIT.Massive budget deficits mean a flood of new supply, which could pressure Treasury-bond prices. Congress recently raised the national debt level to $10.6 trillion.

3. WEAK DOLLAR. Foreigners hold $2.6 trillion worth of Treasury securities. If the dollar continues to lose value, they may decide to unload their Treasuries, forcing prices down (and yields up).