Treasuries seen at risk of “bubble” trouble

Fri Dec 5, 2008 3:29pm EST

By John Parry and Jennifer Ablan

NEW YORK (Reuters) – U.S. government debt, long considered the safest investment in the world, looks like it too has been hit by “bubble” fever.

Prices of U.S. Treasury bonds appear dangerously overstretched after a soaring rally, another sign of how financial markets have been turned on their head.

“Treasuries are the riskiest securities on the planet,” said Tom Sowanick, chief investment officer for $22 billion in assets at Clearbrook Financial LLC in Princeton, New Jersey.

While few fear that the U.S. government will fail to honor its debts, many see a risk that bond prices may plunge just as spectacularly as house, commodity and stock prices have in recent months.

“It looks like the Treasury market is in bubble territory,” said William Larkin, fixed-income portfolio manager with Cabot Money Management, in Salem, Massachusetts.

The rally in the nearly $5 trillion U.S. government bond market picked up speed this week when the Federal Reserve hinted it may buy longer maturity government bonds.

Fears of a bubble in Treasuries underscore how far investors have fled from risk since ballooning house price valuations popped in 2007, causing huge losses in markets across the board and sparking a global economic crisis.

Yields on long-maturing bonds are below 3 percent and only 1-2 basis points on three-month T-bills, the lowest in decades.

After buying billions of dollars worth of government debt, U.S. institutional investors and foreigners including Asian central banks could incur enormous capital losses.

“Treasuries are pricing in depression and I just don’t think we will dive into depression-like activity. I wouldn’t buy them here,” said Brian Gendreau, an investment strategist in New York for ING Investment Management Americas.

That said, the relentless rise in Treasury prices may continue further amid little sign of an end to the panicked exodus from stocks which are down nearly 40 percent this year, and corporate bonds, hurt by fears of default.

Data on Friday showing November as the worst month for U.S. job losses since 1974, which prompted some economists to predict the country’s recession could be longer than previously thought.

“SELF-DESTRUCTING YIELD”

Some investors and economists also fear deflation, an environment of falling prices. That would push yields, or the return for investors on bonds, yet lower than their already five-decade troughs.

The stampede into Treasuries has left the benchmark 10-year Treasury note’s yield, which moves inversely to its price, at 2.51 percent this week, the lowest since the 1950s.

“I think it is safe to say that Treasuries have moved into a self-destructing yield environment,” Sowanick said.

Treasuries got a hefty boost on Monday after Fed Chairman Ben Bernanke said the U.S. central bank might buy long-dated Treasuries. Such a move would help lower mortgage rates and address one of the root causes of the global credit crisis.

Despite the slump in yields and fears of a new bubble, investors are reluctant to move away from their favorite safe-haven. Many fund managers are staring at huge losses in riskier markets and would be unwilling to make big bets there.

“You will have many hiding there, bidding up the market, because many investors can’t stand to lose anymore money before closing the books this year,” Sowanick added.

The latest gains bring the U.S. government bond market closer to the brink of a potentially vicious sell-off. It is now highly vulnerable to a surge of between $1 trillion and $2 trillion of new government issuance to pay for massive bailouts of the financial sector, bond analysts warn.

If that issuance impacts the market just when investors start venturing back into corporate bonds, the fall in prices could be rapid.

“Once confidence returns, which I expect over a six-month time horizon, safe-haven flows will go into some of these markets with more appealing returns such as corporate bonds,” said Ward McCarthy, managing director with Stone & McCarthy Research Associates, in Princeton, New Jersey.

Even if rates do not change over the next 12 months, total returns from the 10-year note would be a measly 2.6 percent versus a 3.4 percent dividend yield for the Standard & Poor’s 500 .SPX index of leading shares.

Doug Kass, president of Seabreeze Partners Management, told Reuters that he is shorting the government bond market, betting on a fall in prices.

“There is huge price exposure in Treasuries and the longer you go out into the Treasury curve, the riskier you are getting,” Kass told Reuters. “What are deemed to be risky, that is equities, are becoming safer and I am gingerly buying.”

(Reporting by John Parry and Jennifer Ablan; Editing by Tom Hals)