Credit events suck, don’t they?
It’s clear Treasuries, and more broadly sovereign debt, are the basis of the credit event given the incredible selloff that’s taken place. I’ve joked before that this Halloween, I will dress up like the iShares 20+ Year Treasury Bond (NASDAQ:TLT) ETF and scare everyone.
Talk about roundtrip. Total return on long-duration Treasuries is back to levels not seen in 11 years. While the popular media keeps focusing on stocks, we are undergoing the greatest devastation in wealth caused by bonds in history.
Ignore the Fake News on Treasuries
Of course, as is usually the case, narrative follows price. Many are arguing that Treasuries are finished as we enter a new inflation paradigm. “Treasuries are no longer the risk-off asset.”
No – this is beyond wrong. I’m actually blown away by how people aren’t understanding what Treasuries represent.
The flight to safety trade is ENTIRELY about credit spreads and default risk repricing. Allow me to make this clear since it seems to be lost on more than a few.
I have no opinion on the longer-term buy-and-hold case for Treasuries with long duration.
The missing ingredient needed for Treasuries to counter stock market volatility is stock market volatility that coincides with credit spreads widening. When volatility in stocks rises, historically, investors in junk debt start to demand more yield. Why? Because heightened volatility increases doubt. Not doubt about interest rates, but doubt over whether the lender of that money to high-yield issuers will actually get their money back.
Investors then realize they need to be compensated with more yield for the risk of the issuer not being able to pay off their liabilities, resulting in money rushing out of risky debt into relatively safer and more collateralized paper where default risk is not as big of a concern.
This ultimately then feeds into Treasuries with duration.
How Government Debt Can Become Risk-Off Again
What’s being missed by nearly everyone as far as how to think about Treasuries as a risk-off trade IS the fact that we have NOT seen credit spreads blow out yet. This is the mechanism that causes money to, for a moment in time, rush into the safety of government debt.
Note that credit spreads appear to very slowly be widening now. This is the first major change this time around. Whether it continues is the question mark (I believe it’s long overdue), but the point remains the same. We don’t know if Treasuries are broken as a flight to safety trade until credit spreads stress tests that thesis.
I believe everyone will be wrong as that occurs.
On the date of publication, Michael Gayed did not hold (either directly or indirectly) any positions in the securities mentioned in this article. The opinions expressed in this article are those of the writer, subject to the InvestorPlace.com Publishing Guidelines.
