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'Operation Twist,' 'Duration Risk' Dangers to Bond Trade

Investors thinking they can find both safety and yield in Treasurys are making a dangerous bet that could begin to unravel soon, especially if the Federal Reserve switches from its easing programs to an updated version of "Operation Twist."

Treasury Building
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Treasury Building

The "Twist" term refers to early 1960s-era operations wherein the central bank sold shorter-dated securities and bought longer-dated ones, in an effort to drive down long-term rates and spur economic growth. Some investors are anticipating that's what FedChairman Ben Bernanke will indicate in his speech from Jackson Hole, Wyo., on Friday.

If he takes that direction, it could thwart the effort of yield-hunters who are hoping that staying long in duration will be a safe bet.

"The risk trade is not 'off,' it has just changed it shape. Investors are still reaching for yield, but they are now doing so by extending maturity in high-quality Treasurys rather than by moving down in credit quality," strategists Martin Mauro and Anurag Bhardwaj, of Bank of America Merrill Lynch, said in a research note. "Investors have swung from seeking credit risk to seeking duration risk."

Under normal economic circumstances, long-term fixed-income investors confronted with such low-yielding government debt would switch to corporate debt or some other type of fixed income.

But with the economy in such a precarious stateand investors highly risk-averse, many are looking to Treasurys both as a safe haven and income producer, despite the much-improved shape of the U.S. corporate balance sheet. Trouble is, shorter-term debt delivers virtually no yield, so they're buying longer-dated Treasurys hoping to get some payoff on maturity if inflationdoesn't erode the value of their investment.

Exchange-traded funds (ETF)that track the Treasurys market have taken in $14.3 billion this year, according to TrimTabs. Four of the top 10 best performers in the ETF space are bull funds indexed to government debt.

Conversely, all bond mutual funds shed $7 billion in the past week alone and $4.4 billion the week before that, marking the heaviest outflow since investors began dumping municipal bonds in December 2010 when analyst Meredith Whitney forecast a major default crisis for 2011. Corporate bonds appear to be taking the biggest hit this time, TrimTabs said.

That's a troubling sign for some bond experts.

"Corporations are actually in quite good shape from a balance sheet and liquidity perspective," said Leslie Barbi, head of public fixed income for the RS Strategic Income Fund in San Francisco. "People would be better served by sticking with credit and sticking with some portion of allocation to high-yield bank loans. There might be more volatility in the short term. But there's been a tremendous widening between the yields you can get on those things and Treasurys."

That doesn't mean investors shouldn't have long-term Treasurys in their portfolios. But they should be used primarily for principal protection, not for yield, said Barbi, the former managing director of fixed income at Goldman Sachs Asset Management and portfolio manager at Pimco.

"The purpose going out on the Treasury (yield) curveserves is protecting principal from now through maturity," she said. "That might be appropriate for some portion of your money. But you'll get better returns during that period by investing in corporate and high-yield bank loans."

Bernanke could opt for a "modified Operation Twist," which could drive down yields as much as 0.35 percentage points from their current already-low levels, wrote Jim Caron, global head of interest rate strategy at Morgan Stanley.

Among the other problems with Treasurys, besides the imminent headline risk regarding the bets being made on Bernanke's speech, are inflation pressures and the uncertain direction of the economy.

Higher yields can work out well for investors holding bonds to duration. But they work against those looking for principal appreciation. Should inflation start to accelerate, for instance, bond holders would lose gains in principal as yields start to rise. The BofAML analysts concluded that it would only take a 0.19 percentage point rise in yield on the 30-year bond to wipe out principal returns over the course of a year.

While Bernanke himself has remained relatively sanguine about inflation threats, Fed Open Market Committee members have expressed increasing worries in that regard. That has led to some speculation that Bernanke may deliver neither another round of quantitative easing nor on Operation Twist, at least in the form that some in the market expect.

"The whole argument is silly from the start," said Kevin Ferry, president of Cronus Futures Management in Chicago. "Operation Twist is over, but it's taking on a life of it's own. So what if they don't do this stuff? That's all we're concerned about at this shop."

Buying longer-duration notes, for instance, would increase the Fed's own risk portfolio and force it to actively manage its bonds should inflation pressures mount. Ferry believes that's exactly the opposite situation in which the Fed wants to find itself.

"Their exit strategy is hold to maturity," he said. "They need to shorten their duration, not lengthen it."

Indeed, investors betting on another round of quantitative easing—a sentiment largely used as attribution for Monday's stock market rally—also could be disappointed.

"The two main drivers behind the flight from credit risk into long-term Treasurys are the expectation that the global economy is headed to recession, and the hope that Fed Chair Bernanke will set the stage for new easing measures," wrote Mauro and Bhardwaj, the BofAML strategists. "Both expectations are open to question."