How many times have we heard or read a major media establishment report that U.S. Treasuries went up because of “safe haven” buying? Stories with this sort of angle have been on the rise lately.
As Europe’s financial crisis escalates, U.S. Treasuries have found new life. Over the past week alone, long-term U.S. Treasury bonds, represented by the iShares Barclays 20+ Year Treasury Bond (NYSE: TLT), have jumped around 4% in value. Treasuries with 7 to 10 year maturities, represented by the iShares Lehman 7-10 Year Treasury Bond (NYSE: IEF), and short term 1 to 3 year maturities have held steady too. Are Treasuries really a “safe haven?”
Let’s analyze this question.
Interest Rates
All bonds, U.S. Treasuries included, are subject to interest rate risk. In today’s market, Treasury prices have been driven up by a cycle of falling interest rates orchestrated by the Federal Reserve.
But as interest rates reverse course and start heading higher, Treasury bond prices fall. If an investor can lend money to a borrower at an interest rate of 4 percent versus 2 percent, the income stream of existing bonds with the lower coupon is less valuable.
Closely connected to interest rate risk is the duration or length of a bond issue’s term. Generally speaking, longer-term bonds with maturities longer than 20 years are more sensitive to interest rate changes compared to intermediate and shorter-term bonds.
Credit Risk
Dagong Global Credit Rating, one of China’s top credit rating agencies, recently cut the U.S. government’s credit score to A+ from AA citing holes in the Federal Reserve’s $600 billion plan to purchase U.S. government debt. The Fed’s strategy is to keep long term interest rates low but Dagong noted the Fed’s move undermines the interests of creditors and damages the U.S. dollar’s value.
Even though many Wall Street pundits and government insiders viewed Dagong’s credit opinion as more of a political statement versus genuine financial research, astute observers can already see the trickledown effect. Overspending at the consumer level has led to catastrophic results. And now overspending at governmental levels threatens the government’s ability to pay its mounting debts.
Other Factors
Supply and demand is probably the easiest concept for most of us to understand. If the supply of U.S. Treasuries outstrips the demand, then values are likely to take a hit.
Treasury auctions are a good way to gauge the demand for U.S. government debt. The U.S. government uses these auctions to determine the yield for four types of debt: Treasury bills (4-week to 1 year maturities), Treasury notes (2 to 10 year maturities), Treasury bonds (30 year maturities) and Treasury Inflation Protected Securities (5 to 30 year maturities).
In 2009 the government held 280 public auctions issuing around $8.6 trillion in new Treasury debt.
The buying and selling activity of foreign nations like China that hold a large quantity of Treasuries is another good indicator of supply and demand.
Conclusion
U.S. Treasuries may have the backing of the full faith and credit of the U.S. government but this does not guarantee them against losing value. Additionally, Treasuries are not immune to interest rate risk or the economics of supply and demand. Furthermore, the credit worthiness of the U.S. government is becoming an increasing threat to the stability of the Treasury market.
The perception or belief that U.S. government debt is “risk-free” is a wonderful myth perpetrated by academic textbooks which are in the process of being re-written. These falsehoods are further evangelized with the help of media types who thoughtlessly repeat them.
Finally, the idea that one type of investment is a “safe haven” or “sure bet” is another fairy tale. The only “safe haven” is having a diversified investment mix that matches your investment goals and that can successfully combat whatever financial uncertainties lie ahead.
This article was written by Ron DeLegge, editor of ETFguide.com. ETFguide is the information leader on exchange-traded funds because of its vendor-neutral approach and its progressive reporting style. Unique features include an ETF bookstore, a monthly e-mail newsletter, and subscription based ETF portfolios.
