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A 'safe' investment turns dangerous
Investors aren't getting paid much, if anything, in the long end of the Treasury market for taking bigger risks. Be careful out there.
By Jim Jubak
Why is the long end of the super-safe Treasury market so dangerous right now?
Any explanation has to start with what hasn't happened in the bond market.
On May 3, the Open Market Committee of the Federal Reserve raised its target for short-term interest rates (the federal funds rate) to 3%. That was the eighth interest-rate hike since the Federal Reserve began to ratchet up interest rates on June 30, 2004. The Fed's short-term target had hit a low of 1% in June 2003.
But after taking a steep jump from 3.33% in June 2003 to 4.73% in June 2004 (when the Fed raised its target to 1.25%), yields on 10-year notes have actually gone down. On Tuesday, May 10, the yield on a 10-year Treasury note was just 4.22%. That's a drop of about half a percentage point, 51 basis points to be exact, while the Fed was raising its target interest rate by 1.75 percentage points.
To see how extraordinary that is, look at what happened to the yield on the very short maturity three-month Treasury bill. Its yield went from 1.29% in June 2004 to 2.88% on May 10, 2005. That's an increase of about 1.5 percentage points, and it just about keeps pace with the Feds interest-rate hikes.
Not much payoff for the extra risk
Yields aren't supposed to behave like this. Investors are supposed to get a higher return for locking up their money for years as opposed to months. That stands to reason when you think of all the things that could go wrong -- higher inflation, a cheaper dollar, a big increase in the trade deficit -- over the life of a 10-year Treasury note. Yet in this case, exactly the opposite has happened since the Fed began raising interest rates.
Last June, an investor got paid almost 3.5 percentage points more in interest to take on the added risk of owning a 10-year note instead of a three-month Treasury bill. In May of this year, the risk premium of the 10-year over the three-month had shrunk to just about 1.3 percentage points.
Thats especially odd when you recall that the Fed is raising interest rates to head off the possibility of higher future inflation, which, if it appears, will diminish the value a 10-year note more than it will a three-month bill.
The core Producer Price Index (PPI), a measure of inflation at the wholesale level that excludes volatile energy and food prices, climbed at an annual rate of 2.6% in March. That was just slightly lower than the 2.8% annual rate of February, and that marked the fastest growth in this inflation measure since November 1995.
Meanwhile, the core Consumer Price Index climbed an annual rate of 2.3% in March, after hitting a two-and-a-half year high of 2.4% in February.
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And it seems especially odd when you compare current yields -- and total returns -- to the historical record of the last 80 years. Over that period, real interest rates on short-term Treasury bills (that is, after you subtract inflation) have been about 0.5% on average. At 2.88% with 2.3% inflation, current short-term rates are slightly above that benchmark. (Since investors hold short-term Treasury bills to maturity, the total return is in effect equal to the yield.)
On the other hand, over that same period the total return on long Treasurys has been about 1.6 percentage points above the total return from the short end -- or in this case, 4.4%. At 4.22%, the current yield doesn't meet that benchmark. Investors at the long end of the market must be, therefore, expecting not only to collect their 4.22% yield, but some capital gains from the appreciation of their bonds. Since bonds bought now will only gain in price if interest rates go down, current investors at the long end of the bond market are counting on a drop in interest rates just to match the historical average total return.
Bond investors beware
These prices and yields make sense only if you're thinking about one of two possible scenarios: Either you're counting on the economy to slow further or, two, you think the financial markets are so risky that you're willing to buy safety at just about any price.
The potential trouble for bond investors is that both scenarios could well be wrong.
The recent report on first quarter U.S. economic growth gave a boost to the first scenario. GDP growth dropped to 3.1% in the first quarter of 2005 from 3.8% in the fourth quarter and 4% in the third quarter of 2004. You can see the trend, right?
But this 3.1% number is just the Advance GDP, the first of three often heavily revised measures of growth in the quarter that the government will release. The Preliminary GDP figures, which replace some projections with real data, will be released on May 26 and there are reasons to believe that the advance 3.1% reading will be revised upward. The March reading on the trade deficit, released May 11, came in below expectations and, in the complex model that produces the GDP number, a lower-than-expected trade deficit almost always leads to an upward revision in the GDP projections in the next round. Watch for the economy to look stronger than it does now after the numbers come out on May 26.
The second scenario is built on a long list of fears. The downgrades of General Motors (GM, news, msgs) and Ford Motor (F, news, msgs) bonds to junk status by Standard & Poor's caused some investors to sell those bonds and buy safer Treasury paper. The flight from corporate paper has been going on for weeks as investors, worried about a slowing economy, realized they weren't being sufficiently rewarded for owning riskier junk bonds. The continued news out of bankruptcy proceedings at companies such as UAL (UALAQ, news, msgs) and warnings of bankruptcy by companies such as Delta Air Lines (DAL, news, msgs) have kept bond investors on edge and wary of corporate bonds.
Given a choice between selling bonds on bad news of stronger growth -- such as the better-than-expected export numbers in the March trade figures -- and buying on fear, the Treasury market is choosing to buy right now. Rumors that a hedge fund might be in trouble sent bank stocks (banks are big lenders to hedge funds) tumbling and Treasury prices climbing on May 11, even though the trade deficit numbers were pushing bonds downward. It certainly didn't slow the flight to safety to have Standard & Poor's downgrade the credit ratings of several complex derivatives, called collateralized-debt-obligations (CDOs), sold by Deutsche Bank (DB, news, msgs). Suddenly the higher yields on the CDOs weren't as attractive as the safety of Treasuries.
Anyone with any experience of the bond market knows that this kind of nervousness is easily reversed. Bond investors have long shown an uncanny willingness to overlook credit problems if the yield is high enough. And as investors sell corporate bonds and derivatives, their prices will drop until one day the yields are attractive enough to produce credit-quality amnesia again.
The simple fact is that right now, investors aren't getting paid very much, if anything, in the long end of the Treasury market for the risks that they are taking. The economy could be stronger than expected (at least in the short run), inflation could indeed be under-reported, fears could give way to greed. All of those could take a big bite out of the capital of anyone at the long end of the Treasury market.
Be careful out there
I certainly understand the desire for safety -- I just don't think you should give up so much yield to get it. Or that you should take on one kind of risk in an effort to flee another.
If you're looking for yield and safety, you'll do much better in the intermediate maturities than in the longer end of the Treasury market. A five-year Treasury note currently yields 3.92%. That's only a tad below the 4.22% of the 10-year Treasury. The long-term historical record shows that five-year notes show almost exactly the same average annual return as long Treasurys. And with about half the volatility since the bond matures in half the time and so much less can go wrong in five years than in 10.
I never like to take on extra risk without getting paid for it. And given all the very real uncertainty in the financial markets, I certainly don't want to increase my chances of taking a loss in my search for safety. Be careful out there.
Changes to Jubak's Picks
Sell Wolverine World Wide
On May 3, I lowered my target price on Wolverine World Wide (WWW, news, msgs) despite the company's improved guidance for 2005. The good news, I concluded, was already pretty much priced into the stock. Today I'm selling the shares out of Jubak's Picks because Europe, a key source of the company's growth, is sliding closer and closer to a true recession. And that, rather than any problems at the company, increases the risk of an earnings miss sometime in 2005. The latest warning signs on European economic growth come out of Germany, where German economists recently cut their already modest forecasts of 1.5% growth for 2005 to 0.7%. And if oil prices keep going up, the semiannual German forecast on the economy noted, even that 0.7% would be too optimistic and the German economy could stagnate for the rest of 2005 and into 2006. I'm selling Wolverine World Wide out of Jubak's Picks with a 28% gain since I added the stock to the portfolio on April 20, 2004.
New developments on past columns
3 ways to capture the September effect
In its April 26 earnings report, gold and copper producer Placer Dome (PDG, news, msgs) showed exactly how badly higher energy prices could hurt. The company reported first-quarter 2005 earnings of 10 cents a share, significantly below the 12 cents a share projected by Wall Street analysts. Revenue fell 3% in the quarter from the first quarter of 2004 due to lower gold and copper production. But higher energy costs were the biggest factor in Placer Dome's earnings miss. Total production cost rose to $342 per ounce from $286 in the first quarter of 2004. Not even an increase in the realized price of gold to $416 an ounce from $398 in the first quarter of 2004 could make up for the rise in production costs. In its conference call, the company lowered its forecast for 2005. In response, the Wall Street consensus for earnings per share dropped to 42 cents for 2005 from an earlier 47 cents. I think that's probably an overreaction. A number of copper producers have noted production problems in their first-quarter reports, and that's likely to stem the recent decline in copper prices. Earnings per share in 2005 are likely to be closer to 50 cents than to 40 cents, in my opinion. I don't see any reason to sell these shares now, despite the beating that I've taken since I added the stock to Jubak's Picks on Sept. 8, 2004. Going into July and the third quarter of 2005, I'd rather own more gold shares than less as a hedge against market volatility and a resumption of the dollar's weakness. But given the cost picture at Placer Dome, I am cutting my target price to $21 a share by December 2005 from the previous $24 a share. (Full disclosure: I own shares of Placer Dome.)
Editor's Note: A new Jubaks Journal is posted every Tuesday and Friday.
E-mail Jim Jubak at jjmail@microsoft.com.
At the time of publication, Jim Jubak owned or controlled shares in the following equities mentioned in this column: Schlumberger and Tejon Ranch. He does not own short positions in any stock mentioned in this column.
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