Treasury bond drama and investment strategies

Conventional investment practice advises holding bonds as a solid, safe, and secure part of a portfolio.

The returns are not spectacular, as is possible in the stock market, but rather a steady stream of income based on the coupon or interest rate of the bond. A bond with a par value of $1,000 paying 4% generates a return of $40 annually over the life of the bond, plus the return of the $1,000 principal. Bonds are issued by corporations, by municipalities, and by the federal government: United States Treasurys are the way the federal government finances its operations. 

Treasurys are a $24 trillion market. The 10-year Treasury is considered the benchmark investment metric for the world, and it is the most widely held global liquid investment, with Japan holding the largest amount, followed closely by China. The U.S. has never defaulted on its sovereign debt, and despite all of our problems, the U.S. remains the strongest and safest economy in the world.

Investors, from individuals to the largest institutional pension funds, measure investments by the risk-free Treasury rate. For example, if I can get 4.5% guaranteed for 10 years from a Treasury bond, what extra return should I expect from a four-plex apartment building to accommodate the risks of holding it? The 10-year Treasury rate influences all sorts of credit, as loan rates from residential mortgages, credit card debt, and business lines of credit are set relative to the risk-free Treasury return.

Treasury bills are issued in many different maturities, from four weeks to 30 years. They have become a media focus recently because, for years, the rate on the 10-year note drifted along at under 2%. Right now it’s at 5%, which is earthshattering for a market where a 15-basis-point move is considered significant. (A basis point is one hundredth of a percentage point). And the Fed has increased rates by 525 basis points since it started on its mission to bring down the rate of inflation. No wonder there is complete chaos and turmoil in the bond market, usually a place where boredom rules. And it is no coincidence that mortgage rates, which hovered around 2%, are now at 8%, the highest level in the past 24 years.

When people talk about the Federal Reserve raising interest rates, they are referring to the federal funds rate. At its regular meetings, the Federal Open Market Committee sets a target range for this rate, which is a reference for the interest rate the large commercial banks charge each other for overnight loans. That rate is a very short-term arrangement: the longer you hold a financial asset, the more risk that asset faces, like inflation eating away the value, economic downturns, etc. So investors look for something called a “term premium” to hold bond assets for longer periods, and a mortgage really is nothing more than a bond. Individual mortgages are grouped together in large pools, and then all the collected mortgage payments those pools generate are sliced and diced into investment-grade tranches. 

There are usually three or four levels of risk that investors can choose from when they buy the resulting bonds, called MBS, or "mortgage-backed securities.” The risk calculations reflect the possibility of pre-payments, credit risk, defaults and foreclosures, market valuation drops, and so on. Mortgage rates therefore build in a term premium compared to the safety of holding risk-free Treasurys.

So, why the dramatic surge upward, and how long will this persist? The surge in the 10-year Treasury we have seen over the past six months resulted from the Fed’s aggressive rate-increase strategy. But despite the efforts of the Fed to strangle the economy, the American job market and consumer spending have remained strong, so the Fed has kept interest rates high to slow down this momentum. Therefore, it has to price its own cost of capital (the Treasury auctions) in line with its own interest rate increases. And because the 30-year fixed-rate mortgage competes for capital investment with the Treasury, it has stayed high too. 

It isn’t just residential and commercial property mortgage rates that are affected; it is all debt. The recent turmoil in the bond marketplace stems from the investment calculus that a bond with a face value of $1,000 paying 2% is not worth the face value; in order to meet a current interest rate return of 6%, that bond will trade for less than its principal amount in order to generate a higher return. While the devaluation of the previously-issued bonds is occurring, there are new batches coming out every few weeks. 

The latest auction of Treasury securities was scheduled for Nov. 1, when about $1.3 trillion of new debt was sold off. The U.S. deficit is about $33 trillion, and almost 6% of the GDP goes to paying off interest. Politicians, economists, and everyone else agree that these spending levels are unsustainable, but nothing is being done to rein in the deficits. Higher interest rates are one of the consequences, and these rates are not coming down anytime soon.

Raphael Barta is an associate broker with an active practice in residential, vacant land, and commercial/investment properties. Raphaelb@sandpoint.com.