In the 1980’s film “Caddyshack”, Judge Smails (played by the late Ted Knight) emphatically uttered, “Well, we’re waiting!” to Danny Noonan on a make-or-break put to decide a golf wager in the movie’s finale. The movie was responsible for many memorable quotes but this one in particular seems poignant for today’s bond investors. Despite individual investors’ widespread belief that bond yields will rise, and rise steadily, the Treasury market remains resilient much like the gopher from Caddyshack. Last week the benchmark 10-year Treasury note increased in price, capping a strong month for Treasury performance, and the yield declined to 3.66%, a lower yield level than at the start of the year.

Treasury market action last week was all the more impressive considering it occurred despite a record $129 billion worth of Treasury auctions and the uncertainty that typically surrounds a Federal Reserve Federal Open Markets Committee (FOMC) meeting. Flight-to-safety flows from the Greek funding crisis benefited Treasuries early in the week but strong demand at the Treasury auctions enabled Treasuries to hold, and in some cases, build upon gains from early in the week. Interest in Treasuries was strong enough that investors disregarded the risks of the Fed potentially signaling a shift in monetary policy
to bid strongly at the auctions. The benign Fed statement would ultimately end up being a positive for bonds later in the week.

Both foreign and domestic investors have remained steady buyers of Treasuries.

Foreign official buying is arguably best reflected in the weekly change in custody holdings at the NY Federal Reserve. This data is more timely than the Treasury International Capital System (TICS) data, which is released with a lag and can be subject to substantial revisions. Banks have also been steady buyers as well and actually increased purchases since the end of the financial crisis. Banks have chosen to buy safe securities as a way to rebuild balance sheets rather than increase lending. Bank buying of Treasuries is not uncommon following a recession and has historical precedent. The last time bank purchases of government bonds (of which Treasuries are the bulk due to the small size of the agency market) accelerated in a similar manner was after the 2001-2002 recession.

The Treasury Department may provide Treasuries an additional lift this week at Wednesday’s quarterly auction announcement. The quarterly announcement not only outlines the dollar amount of the following week’s 3, 10, and 30-year auctions, but also includes a discussion of potential changes to the entire Treasury auction schedule, such as change to the frequency of a particular
auction or the introduction of a new security.

As part of its guidance on bond issuance overall, the Treasury may announce that the dollar amount of regular Treasury note auctions may begin to decrease at some point over the third quarter of 2010. Since record Treasury supply has been one of the leading arguments from the bond bears as to why Treasury yields should increase, a possible reduction in auction sizes is noteworthy. A reduction in new Treasury issuance would be made possible due to a slight reduction in the budget deficit. After reaching a negative $1.5 trillion in fiscal year 2009, the budget deficit for fiscal year 2010 is expected to be a negative $1.33 trillion, or 9.1% of GDP (Gross Domestic Product), according to the average of a monthly Bloomberg survey of 13 economists in April. Of note, the average forecast was revised lower, from 9.3% of GDP, compared to forecasts in the March survey suggesting the improvement is occurring faster than anticipated.

Risk for Treasury Supply

Although the dollar amount of Treasury issuance may have peaked, Treasury supply remains a risk for bond investors for three primary reasons:

  • The Treasury Department is still in the midst of extending the average maturity of outstanding Treasury debt. The average maturity has rebounded from a historically short-term level and the Treasury Department intends to increase from 62 to 70 months over the coming few years. Shifting towards longer-term bond issuance requires that investors be willing to take greater interest rate risk. So far, the markets have accommodated this shift but stronger-than-expected economic growth or Fed rate hikes could change the market’s willingness to buy a greater portion of more interest rate sensitive bonds.
  • While new issuance may have peaked, recently issued bonds will remain outstanding for years and the Treasury’s borrowing needs will remain significant. The non-partisan Congressional Budget Office forecasts steady growth in U.S. Treasury debt over this decade.
  • Foreigners have been a steady presence in the Treasury market but it remains to be seen if the pace will be sustained over coming years. An ever-increasing dollar amount of purchases will be required to maintain this market share amidst an expanding Treasury market. A continued rebound in global GDP will help provide additional cash to increase Treasury purchases but should foreign demand wane it would likely exert upward pressure on interest rates all else equal.

Currently there is no alternative to the depth and liquidity of the Treasury market for foreign investors. Therefore, the above factors may take months or years to fully manifest in the bond market.

The wait for higher yields is a keen focus for two groups of bond investors. On the one hand, income-seeking investors would welcome higher yields as it would help meet their income objectives. On the other hand, non-income focused investors (those buying bonds primarily as a diversification tool or to enhance overall portfolio total return) remain nervous and await the right signal to shift out of intermediate maturity bonds and into less interest rate sensitive short-term bonds.

Both groups may be shouting, “well, we’re waiting!” with regard to higher yields. However, bond investors may very well have to wait a while longer. We do not believe a sharp rise in interest rates is likely over the near-term as Treasury buying habits outlined above will be slow to change. Furthermore, inflation remains subdued and concerns over European sovereign debt persist, both of which lend support to purchases of U.S. Treasuries. We remain focused on intermediate bonds and their greater income generation. We continue to believe the 10-year Treasury note yield will finish the year between 4.0% and 4.5%, which comprises a yield increase of roughly 0.3% to 0.8% based upon a 10-year Treasury yield of 3.70% as of May 3, 2010 according to Bloomberg. In our view, this represents a manageable rise in interest rates that equates to a 2010 bond market total return in the flat-to-mid single-digit range as measured by the Barclays Aggregate Bond Index.


  • The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance reference is historical and is no guarantee of future results. All indices are unmanaged and cannot be invested into directly.
  • Government bonds and Treasury Bills are guaranteed by the U.S. government as to the timely payment of principal and interest and, if held to maturity, offer a fixed rate of return and fixed principal value. However, the value of funds shares is not guaranteed and will fluctuate.
  • Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise, are subject to availability, and change in price.
  • Treasury International Capital (TIC): Select groups of capital, which are monitored with regards to their international movement. Treasury international capital is used as an economic indicator that tracks the flow of Treasury and agency securities, as well as corporate bonds and equities, into and out of the United States.
  • TIC data is important to investors, especially with the increasing amount of foreign participation in the U.S. financial markets.
  • International and emerging market investing involves special risks such as currency fluctuation and political instability and may not be suitable for all investors.

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