ETF Trends
ETF Trends

US Treasury bond yields keep going down, while the risks are rising. While this asset class keeps getting bid, I believe there are more attractive options out there that offer less risk and better returns than the US Treasury.

Earlier this year I wrote about the growing dominance of the Fed, and other public institutions, in the US Treasury market. As I discussed at the time, research by my colleague Antti Petajisto showed that in 2011 the Fed, along with international public sector buyers, took down more than 100% of the new supply of Treasuries of 5-year maturities and over. With Treasury yields hitting an all-time low of 1.40% in July, it should come as no surprise that this trend has continued into 2012.

Through its extension of Operation Twist, the Fed continues to purchase roughly $45 billion of long-dated Treasuries each month. In addition, foreign official sector buying has also kept pace with recent patterns. As a result, the Treasury market is passing a significant milestone: The Fed will soon own more long-term Treasuries than the entire private sector.

There are two major implications for this structural change in the market for US long-dated debt:

  • First, there is an ever-shrinking supply of high-quality debt available for the private sector. With Europe still mired in recession and with no clear path to fiscal union, the number of AAA-rated issues globally is declining. With the United States one of the few remaining countries whose bonds are mostly AAA- rated, many institutional investors are effectively compelled to own these bonds, regardless of their view of the long-term value.
  • Second, with the private sector receding from this market, the typical metrics that investors used to gauge the direction of the Treasury market have been rendered largely irrelevant. Historical measures of value or signs of investor demand matter less when the marginal buyer is either a public sector institution, like the Fed, or a bank or insurance company that needs to own AAA bonds. In both cases, the buyer is less sensitive  to the price.

While yields may remain low–or as long as the Fed is willing to maintain a bloated balance sheet–investors looking to maximize their returns should still be looking for alternatives. Even if rates don’t rise, without a steep and prolonged drop in inflation, long-dated Treasuries are still yielding below the level of inflation. In other words, unless you believe we’re headed toward Japanese-style deflation investors are accepting a negative real-return to lend to an entity with deteriorating credit quality. In addition, with coupon payments so low the duration, or interest-rate risk, of any given maturity has risen dramatically. Investors are not only acquiescing to low returns, but they are accepting more risk for the privilege.

I continue to believe there are better alternatives in the fixed income space. Specifically, I continue to like US investment-grade and municipal bonds, both of which have outperformed the broader bond market year-to-date. For investors with higher income needs, high yield bonds also appear worthwhile. In short, the Fed or foreign central banks may have a motivation to overpay for US Treasuries; private sector investors have better options.

Russ Koesterich, CFA is the iShares Global Chief Investment Strategist and a regular contributor to the iShares Blog.