“As has become abundantly clear this summer, the federal government has a debt crisis. In the past 10 years, U.S. Treasury obligations have risen from less than $6 trillion to more than $15 trillion. Normally, a borrower loading up on debt in this manner becomes less creditworthy. Indeed, Standard & Poor’s just dropped the credit rating of U.S. debt from AAA to AA+. (Moody’s and Fitch, the other two rating agencies, affirmed their AAA rating.)
“Regardless of whether you think that the downgrade was justified, it’s certain that the need to borrow excessively must affect the credit quality of the U.S. government in the minds of investors. What’s more, most of the additional debt has accumulated since the financial crisis hit the headlines three years ago. Normally, under such conditions, a borrower would have to pay higher yields to attract new money. But that has not been the case with the U.S. Treasury. The key 10-year Treasury Note now yields barely 2%, which is nearly a record low.
“Ten years ago, a much more solvent U.S. Treasury was paying more than 5% on its 10-year obligations. Thus, in the face of diminished creditworthiness, yields have fallen sharply. Lower yields mean higher prices. Investors holding Treasuries and Treasury funds have seen their portfolio values rise, even as federal debt more than doubled. There are several reasons for this unexpected result. Perhaps most important, the U.S. dollar is still the world’s reserve currency. Nothing else comes close. The Euro would be a poor substitute, considering all the fiscal issues facing many European nations. In troubled times, investors flee to safe havens. We saw that at the height of the financial crisis of late 2008-2009. Even as most stocks and many bonds lost value then, rising demand for Treasuries sent prices much higher. A similar phenomenon is taking place this summer, boosting the price and depressing the yield of U.S. Treasuries.
“What does all this mean to investors? For one thing, standard Treasuries don’t appear to be good investments now. How much lower can yields go? If rates move up, your investment will lose value. The 2% rate won’t be appealing in a 5% environment. To sell your security, you would have to reduce the price to provide a 5% yield to the customer. If you want safety and a sure return of your principal, put your money in the bank. Federal deposit insurance covers accounts up to $250,000 per bank. It’s true that you’ll get little or no yield, but you’ll have ready access to your money.
“Treasury yields are so low that long-term issues are unappealing. If you think there is a risk of inflation, do you want to lock up your money now for 10 years, at 2%? The Fed has just announced it will keep short-term rates low for the next two years, so rolling over short- term T-bills will not produce much of a return.
“Treasury Inflation-Protected Securities (TIPS) also have a scant yield now. But with TIPS, you’ll get a principal increase that keeps up with the inflation rate so you might put some money into TIPS or a TIPS fund as a hedge against possible rises in the cost of living.
“Elsewhere in the bond market, municipal issues have come under pressure. S&P has lowered the ratings on thousands of munis, including some that are linked to Treasuries. Even so, muni prices have generally held up, so yields on munis are also low. High-quality munis now yield about the same as Treasuries. While it is hard to get excited about 2% a year for the next 10 years, keep in mind that yields on tax-free municipal bonds are usually lower than yields on taxable Treasuries. In the current market, tax-exempt bonds are actually throwing off more after-tax income than taxable Treasuries. Nevertheless, they are not the screaming buy they represented in the 1990s, when high-grade municipals were yielding 9% or more.
“Where can you do better? One place is in U.S. corporate issues. American corporations are typically in good financial shape. Many companies have cut overhead sharply, including debt service, and profit margins are up significantly. Today, you can get yields of 4% or more on highly-rated U.S. corporate bonds. Even after tax, you’re way ahead of where you’d be with munis or Treasuries.
“High-yield (junk) U.S. corporate bonds now yield 8% or more. Obviously, the market feels that a weak economy will lead to a wave of defaults by issuers of low-rated or unrated bonds.
“Even the worst economy, though, shouldn’t produce a deluge of defaults among high-yield bonds. If you are a long-term investor in a fund with a well-selected assortment of junk bonds, you’re likely to wind up with a total return (cash yield plus or minus principal movements) greater than the return you’ll get from higher-rated bonds. That’s not saying that you should load up on junk bonds. Rather, you should broaden your ideas about what bonds you want to own. If you stick solely to what might be considered traditional holdings (standard Treasuries and high-quality munis), you probably will get principal preservation but little return. By mixing in some other kinds of bonds, you may be able boost your total returns. Those additions could include TIPS as well as high-quality and high- yield corporate bonds. ...
“Of course, a diversified portfolio of dividend-paying stocks of high-quality U.S. companies is a great way to build wealth. Today, there are many companies with balance sheets that would be the envy of the U.S. government that produce sufficient income to pay dividends in excess of 3%. Look to this month’s portfolio for some suggestions in that regard. Ironically, companies like Johnson & Johnson (JNJ), whose dividend yields 3.6% (as this is written), still carry a AAA rating, which is higher than the U.S. government, but their bond yields have fallen below what an investor can receive in dividends. More important, by owning its stock, you get the potential for price appreciation and the likelihood that it will continue to extend its streak of 49 consecutive annual dividend increases.”
Vita Nelson, Vita Nelson’s The Moneypaper, September 2011
