Go figure: Demand for U.S. Treasuries soars

10/19/2009 9:25 am EST

Focus: STOCKS

Jim Jubak

Founder and Editor, JubakPicks.com

 

They pay almost nothing. They're denominated in a currency that is losing value every day.

And yet investors keep loading up on U.S. Treasuries.

Overseas buyers increased their holdings for a fourth consecutive month in August, to an all-time high of $3.45 trillion, according to the U.S. Treasury Department.

U.S. buyers are also flocking to Treasuries, largely through bond mutual funds. Eighteen times more money has flowed into fixed-income funds than into stock funds in 2009, according to Morningstar. 

The U.S. trend is relatively easier to understand. U.S. investors aren't taking any currency risk since they're putting dollars in and taking dollars out. At a time when the U.S. savings rate is climbing, there's more money looking for a home. And after two bear markets in stocks in the last decade bonds look safer than stocks.

It's harder to figure out why overseas investors continue to snap up bonds. With the dollar falling against just about every currency in the world, for most overseas investors an investment in dollar-denominated bonds brings a constant erosion of value in the home-country currency.

The exception, of course, is for anybody paying renminbi for U.S. Treasuries. China has effectively re-pegged its currency to the dollar this year and that removes currency risk.

And, of you take a look at comparative total returns, an investment in U.S. bonds isn't as insane as it seems for buyers who want to be in bonds somewhere in the world.

Sure the dollar is falling and a 10-year Treasury pays just 3.4%--below the  5.6% yield on on the Australian 10-year government bond, for example--but the Federal Reserve isn't raising interest rates any time soon and investors anticipate--rightly in my opinion--that overseas central banks are likely to start raising interest rates later this year or in early 2010 at the latest. The Australian central bank has already raised short-term interest rates by 0.25 percentage points.

It doesn't take a big increase in interest rates to wipe out that differential in yields. For example, an Australian 10-year bond issued with a coupon yield of 5.25% now yields 5.6%, but only because after the Australian central bank raised interest rates, the price of the bond sank. A bond initially purchased for $10,000 now sells for just $9750.

 (The prices of existing bonds go down as interest rates climb since investors have the option of buying newly issued bonds paying the new higher interest rate. So the price of the existing bond falls until it's yield matches that available from a newly issued bond. Holders of the bond take a hit to their capital.)

So yes, the holder of the $10,000 Australian bond initially yielding 5.25% makes $525 in annual interest versus just $340 in interest for the holder of the 10-year U.S. Treasury, but the Australian bond is also worth $250 less than it was when initially purchased.

bat wipes out all the difference in yield--and more. Buying the U.S. Treasury  isn't as insane as it seems on the surface.

Assuming the the dollar continues to decline at a measured rate instead of going into a free fall.

And assuming the the Federal Reserve doesn't raise interest rates, cutting into the value of existing bonds, anytime soon.

As I laid out in my October 14 what to worry about post http://jubakpicks.com/2009/10/14/know-what-to-worry-about-and-when-if-you-dont-want-to-get-spooked-out-of-a-rally-or-get-killed-in-a-correction/ the big test for the financial markets will come when the Federal Reserve starts raising interest rates.

That's still a long way off.  But once the Fed signals that interest rate increases are no longer off the table, bond investors will rethink their current love for Treasuries.

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