- While it’s popular to say that U.S. government bonds are in a “bubble,” the factors that have supported the market in recent years remain in place as we move into 2013.
- Having said this, yields are so low that the upside for U.S. Treasuries is very limited at this point – and it’s only a matter of time before rates begin to rise. In this sense, the risks outweigh the rewards regardless of how many positive factors are supporting the market.
- TIPS are largely affected by the same factors as plain-vanilla Treasuries, but the demand for inflation protection may continue to provide support to the asset class.
Treasuries: Bubble or Safe Haven?
Yields on U.S. Treasuries are closing out 2012 near historically low levels, and they are sitting well below their long-term average. Many pundits are therefore offering predictions that Treasuries are highly vulnerable to rising yields and a corresponding downturn in prices. (Keep in mind, prices and yields move in opposite directions.) While it's possible that Treasuries could collapse in 2013, there are a number of favorable underpinnings that should continue to prop up the market.
U.S. Treasuries Still Have Plenty of Support
Treasury yields are indeed very low – indicating that there is more room for them to rise then to fall – the four key pillars of support for Treasuries in the 2011-2012 time frame remain in place as we move into 2013, which makes a near-term meltdown unlikely:
1) Fed policy: The Fed has stated that it has no intention of raising short-term interest rates until 2015. As a result, the Fed’s policy will almost certainly continue to depress yields on shorter-term Treasuries. In addition, the Fed has announced that it will resume direct purchases of Treasuries through its quantitative easing program - meaning that Treasuries will have a source of persistent demand throughout the year.
2) The safe haven trade: The “flight to quality” trade – in which investors seek shelter from broader, global concerns by moving cash into safer investments – can continue to benefit Treasuries in 2013 given the lack of a resolution to the European debt crisis and the ongoing tension in the Middle East. The flight to safety rescued Treasuries from downturns on multiple occasions in 2012, and there’s little to suggest that will change in the year ahead.
3) Inflation is tame: Inflation remains low, and there is no sign of any inflation on the immediate horizon despite widespread concern that the stimulative policies of the U.S. Federal Reserve will lead to higher prices.
4) Slow growth environment remains in place: Economic growth remains stagnant, and with higher taxes on tap for 2013 there is little to suggest that it will accelerate from its current rate in the 1-2% range. (Stronger economic growth makes the Fed more likely to raise rates, which hurts bond prices, while slower growth does the opposite).
The Fiscal Cliff
The fiscal cliff, or the set of tax increases and spending cuts set to go into effect a year-end, also could have a major impact on the market. In the unlikely event that policymakers fail to come to an agreement and the country “goes over the cliff,” it is likely that a recession would result. In this situation, it would be reasonable to expect that Treasury yields would fall back to their lows of July 2012 (as prices rose), and TIPS would likely follow. However, the most likely outcome of the debate is that the two sides will come to an agreement at the last minute, averting the worst impact of the fiscal cliff on the economy. In this case, Treasuries would likely experience a short-term sell-off as the flight to quality reversed.
The Upside is Severely Limited from Here
Even with all of these factors supporting the market, there is little chance of another rally similar to what we witnessed during the past two years. Based on data available on November 28, a drop in the 10-year Treasury note from its closing yield of 1.62% all the way to zero would only generate a one-year return of 16.4%. Even a drop to 1% would garner investors a return of just 7.3%. This indicates that even in the wildest-best case scenario, the low yields on Treasuries severely limit the potential for price appreciation. As a result, Treasuries are likely to act more as a "parking place" for cash than a source of compelling, inflation-beating total returns.
The Key Question: Is the Reward Worth the Risks?
In summary, the potential downside for Treasuries is much higher than the potential upside – particularly if any of the factors that have been supporting the market change in the year ahead. While the worst-case scenario is unlikely to unfold in 2013, investors need to be mindful that the tradeoff of risk and reward is now tilted against them. This is a key consideration for anyone invested in bond index funds, where Treasuries typically carry a heavy weighting.
A Shaky Longer-Term Outlook for Treasuries
Looking past the outlook for 2013, investors need to keep in mind that yields are as low as they are due to the Fed’s interference in the market. Once the Federal Reserve inevitably withdraws the support it has provided through ultra-low rates and policy initiatives such as quantitative easing and “Operation Twist” investors will likely turn their attention to the massive debt problems of the U.S. government. At some point, policymakers’ unwillingness to match revenues and expenses could drive up U.S. interest rates as investors seek compensation for the added risks in the form of higher yields. Once this scenario eventually unfolds, the bear market for U.S. Treasuries will begin – and it’s largely a question of when, not if, this will occur.
A Different Story for Buy-and-Hold Investors in Individual Bonds
Even if Treasuries do collapse, they can still play an important role for investors who buy individual bonds and hold them to maturity: while they won’t provide a great deal of yield, they’re safe and they provide a shelter against volatility in other segments of the financial markets, and in the case of Treasury Inflation-Protected Securities (TIPS), they can also provide inflation protection. The risks are primarily for those who own bond mutual funds and exchange-traded funds, or who need to sell prior to their bonds’ maturity date.
2013 Outlook: TIPS
Treasury Inflation-Protected Securities (TIPS) are in a similar boat as Treasuries. There is no clear catalyst for an immediate sell-off, and the continued demand for inflation protection provides an important source of support for the market. At the same time, however, there is a the potential for meaningful downside if one or more of the four pillars mentioned previously gives way in the year ahead. This is important to keep in mind, since many investors may be complacent following 6%-plus gains for TIPS in each of the four calendar years from 2009 through 2012.
In this sense, the outlook for TIPS is straightforward and close to that of Treasuries: they’re unlikely to fall sharply in the immediate future, but their upside is capped by low rates.
Investors in TIPS funds need exercise a greater degree of caution. While individual TIPS can provide longer-term inflation protection, funds such as the iShares Barclays TIPS Bond Fund (ticker:TIP) can’t be considered “safe” just because the underlying securities are issued by the government. If higher inflation causes interest rates to rise, the potential price declines will outweigh the element of inflation protection by a wide margin. In this sense, TIPS funds won’t provide the hedge against inflation that many investors may be expecting, and they may in fact prove to be highly inflation sensitive. This issue is covered in greater depth in my article What are the risks of TIPS funds?
Individual investors who are concerned about inflation may therefore consider inflation-indexed savings bonds, the case for which is outlined here.
The Bottom Line
Put it all together, investors should expect the following from government bonds in 2013:
- Continued low yields
- Higher volatility
- Less price appreciation than we’ve seen in recent years
- A continued pattern of performing well when investors are frightened, and weakening when risk appetites improve
More on What to Expect in 2013:
Disclaimer: The information on this site is provided for discussion purposes only, and should not be construed as investment advice. Under no circumstances does this information represent a recommendation to buy or sell securities. Always consult an investment advisor and tax professional before you invest.