Last month, the government put $25.5 billion of 10-year Treasury notes up for sale. The notes carried a 1.75% interest rate, well below the inflation rate. Anyone who bought a note would lose money to inflation for a decade.
Who would take that deal? Plenty of people, apparently. The Treasury received $2.90 in bids for every $1 in T-notes it offered.
Treasury yields have been falling since 1981, when the 10-year T-note yielded more than 15%. At current record-low levels - 1.66% - Treasury yields have much more room to rise than fall. Yet investors can't get enough of them.
Is this yet another bubble, like tech stocks in the 1990s and junk mortgages in the past decade? Surprisingly, most experts say probably not. Instead, the public's taste for Treasuries has been whetted by the bursting of other bubbles - specifically, the housing bubble and the European debt bubble. "Everything else was a bubble," says Peter Kendall, co-editor of the Elliott Wave Financial Forecast. "The Treasury market was the safety valve."
A bubble has a very specific meaning in finance: It's not just the normal top of a bull market. A bubble is a period of widespread, overwhelming belief that an investment will continue to soar higher, no matter how high prices have already moved. In other words, an ordinary bull market is not a bubble. It probably is a bubble when everyone from your taxi driver to your pension fund manager loves an investment.
Supposedly, Joseph Kennedy, father of President Kennedy, realized the 1929 stock market was a bubble when his shoeshine boy started offering him stock tips. Kennedy figured that if everyone was in the market, there weren't many people left to push up prices.
Quite a love affair
You can certainly make the argument that investors love bonds dearly. Investors have put an estimated $864 billion into bond mutual funds from the start of the bull market in stocks in March 2009 to the end of May. They have yanked nearly $200 billion from traditional open-ended stock funds during the same period.
And it's not just mutual fund investors who are in love with bonds in general and Treasuries in particular. China owns $1.2 trillion of Treasuries. Japan owns $1.1 trillion.
The most recent 10-year T-note auction wasn't the most frenetic. That honor goes to the Dec. 13 sale, when the Treasury got $65 billion in bids for $25.8 billion in T-notes. At the last auction of 28-day Treasury bills - investment rate 0.041% - the Treasury got a staggering $148 billion in bids for $33.8 billion in available T-bills.
Axel Merk, manager of the Merk Hard Currency fund, thinks that the Treasury market has been disturbingly quiet. "When you buy long-term bonds, you have volatility - it's a wild ride out there," he says. "In recent years, it's been very smooth sailing, and when volatility goes below the historic norm, that's the definition of a bubble."
The danger with any bubble is when it bursts. People who trade bonds for a living are usually concerned with the price, rather than the yield. Bond prices rise when interest rates fall, and vice versa. If rates were to rise 1.5 percentage points, a current 10-year T-note would fall 23% in price. A 30-year Treasury bond would fall 47% with a similar rise in yields.
Marc Faber, editor of the Gloom, Boom and Doom report, says this in an e-mail: "The Nasdaq was in a bubble at the end of 1999. It still managed to rise 30% to the March 2000 peak. Thereafter, it was all the way down. Possibly Treasuries rally more, but after a bull market, which began in September 1981, we are surely approaching a major low in interest rates. I am sure that over the next 10 years investors buying today U.S. 10-year T-notes and 30-year bonds will lose a ton of money."
Nevertheless, if you ask most people on the street for an investment tip, it's unlikely they would answer "A 10-year Treasury note." Much of the inflow into bond funds has gone into funds that invest in anything but Treasuries - and pay higher yields, such as junk-bond funds.
In fact, many investment managers don't like Treasuries, either. Not only are yields at near-record lows, but prices are at near-record highs. In the upside-down world of bonds, yields fall when prices rise, and vice versa. "I don't hear anyone saying, 'You know what? 1.6% is the number I've got to own,' " says Philip Barach, president of DoubleLine. "It's now a trading vehicle."
Kendall notes that a bubble typically means unabashed enthusiasm for an investment, and that doesn't seem to be the case at the moment. He's more worried about the flood of investors into riskier bonds, such as high-yield junk bonds. "We're bearish on junk and corporate bonds," he says.
So who are all these people trading Treasuries? The largest holder of Treasury securities is the federal government, which owns $6.4 trillion of them. The figure includes special bonds issued by the Social Security trust fund and other government agencies. Essentially, it's debt the government owes to itself. Aside from that, the Federal Reserve Bank owns $1.7 trillion in Treasuries. The Fed's buying is mainly for monetary policy - which, currently, is to keep rates low.
Next up are foreigners, who own $5.1 trillion of Treasuries. Why do foreigners love Treasuries so? In large part, because they're not denominated in euros. German government bonds are, arguably, ultra-safe, too. "You know you're going to get your money back, but you're just not sure about the euro," Barach says.
And German bonds yield less than Treasuries. A 10-year German government bond yields just 1.25%. Japanese 10-year bonds yield 0.85%. And, even if a foreign investor wanted to buy European government debt, the bond markets are nowhere near as large or as liquid as the market for Treasuries.
"If you have a trillion dollars, you can't put it there," Barach says.
The U.S. government debt market is the largest in the world. The second-largest is Japan, which has suffered low yields for over two decades. The third-largest bond market is Italy's, and their 10-year government bonds yield 5.8%. Except they're denominated in euros. And, well, issued by Italy.
And, at the moment, there's a reason why bond yields are so low: The economy is stuck in low gear, unemployment is 8.2% and the rest of the world isn't in better shape. Furthermore, the Federal Reserve has said that short-term interest rates will remain extremely low through 2013, which makes it less likely that longer-term bond yields will soar.
"We're going to stay in a low-rate environment," DoubleLine's Barach says. Even if they rose 1.5 percentage points, rates would be historically low. The 10-year Treasury has averaged a 6.2% yield since 1954.
Currently, at least, the amount of fear in the world justifies ultra-low Treasury yields.
"When fear comes, your greatest concern is not losing money, and that means a rush to Treasuries," Barach says.
So, if Treasury rates are low, it's because the economy is depressed and the rest of the world looks horrible - not that the entire investment community believes that rates have nowhere to go but down.
"Treasuries were for a long time an alternative to what was bubbling," Kendall says. "Now it's just an overbought market, primed for reversal."