$TARRBUCK FOR OCTOBER 2011: TOXIC TREASURIES

TOXIC TREASURIES

Long term US Treasury yields are at historic lows : 2% for ten-year bonds, 3% for 30-years. You have to go back to the Truman and Eisenhower administrations to find yields this low. There’s a good-news-bad-news story here. Investors are betting on the solidity of the US Treasury and the US dollar in a time when everything else looks too risky by half. That’s the good news. And it’s right. There is absolutely ZERO chance of the US government defaulting on its dollar-denominated debt. Why ? Because it can always print more dollars to pay off the debt. And if the Treasury won’t do it, the Federal Reserve System will. That debt will be paid.

The bad news is that there is nowhere for Treasury yields to go but UP. And as yields go up, bond prices fall. So if you buy a 30-year T’bond now, and yields go up to 6% in a few years, your bond will be worth 65 cents on the dollar. You’ll get paid off, but if you need to liquidate before maturity, you’ll take a loss. And why should yields go up? The bonds are currently pricing in low inflation and low productivity of capital. When an economic expansion gets going, inflation or real returns to capital have to go up. And with that, interest rates, eroding the market value of your bonds.

Treasuries are expensive now because investors are scared of everything but inflation and prosperity. If either of those occurs, they’ll have another thing to be scared of.

What’s a fixed income investor to do? Ladder the portfolio, emphasizing the short end with its lower risks and lower returns; CD’s at 1% instead of T’bills at 0.10%; muni’s at an historically high yield premium over Treasuries.

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