Suppose Alan Greenspan is right about projected federal-government surpluses, and Uncle Sam really will have the coin to retire the publicly held national debt and then accumulate stores of assets. The Federal Reserve chairman articulated his perspective on April 27, in an address to the Bond Market Association. Even though financial advisors and money managers don't necessarily buy it, let's face it: Forecasts show Washington eliminating today's $3 trillion of market-tradable debt sometime between late 2003 and 2007.
What's the effect of a tax cut on those prognostications? Not much. Even a huge $2.2 trillion tax trimming sought by one zealous member of Congress, Rep. Tom Tancredo (R-Colo.), would merely delay the demise of Treasuries until 2010.
Let the politicos and economists debate the relative merits of having the government-securities market vanish completely, or not. (Key issues include national-security considerations-with no active market, how would the government raise cash quickly in the event of a crisis?-and whether Washington, like a business, should employ prudent amounts of low-cost leverage to advantage.) For advisors with clients who own fixed-income instruments or have a dire need for paramount safety, the salient point is that the Treasury supply is dwindling.
During the four-year period ended March 31, the amount of Treasury notes (U.S. debt issued with original maturities of two to 10 years) available in the marketplace declined 28% as paper matured without dollar-for-dollar replacement. And $43 billion, or about 6.5%, of T-bonds (original maturities of more than 10 years) have been yanked from the market since Treasury inaugurated a debt-retirement program last year. Meanwhile, the U.S. government securities portion of the Lehman Aggregate Bond Index slid from 46% at the end of 1995 to 25.4% at the end of March. With continued attrition a given for at least the foreseeable future, even investment managers who scoff at predictions of a debt-free federal government are taking action.
"We're investing our portfolios heavily in investment-grade corporate bonds," says Marc Seidner, a director in the fixed-income department of Standish, Ayer & Wood, the respected Boston money-management firm. "We think that investment-grade corporate bonds are incredibly attractive in terms of their absolute yield levels and also their return advantage relative to Treasury bonds."
Indeed, the word on Wall Street is that perceived scarcity has made Treasuries overpriced, and their current low yields are indicative of prices having been bid up. With Treasury yields artificially low, their spread to corporate yields is unduly wide. Should the spread narrow, corporate bonds will show better price performance than government debt, which is why many money managers see corporate paper as an attractive alternative to evanescing Treasuries.
"The single-A corporate-bond index had a spread of 168 basis points over Treasury bonds at the end of March," Seidner says, noting that the average spread for the last 16 years has been 92 basis points with a standard deviation of 30 basis points. "That makes single-A corporate bonds 2.5 standard deviations cheap to their historic average-which tells me that the current yield advantage is pretty attractive," says Seidner.
"This year, corporate bonds should be the best performing sector of the U.S. bond market," adds another institutional investor, Michael Materasso of Fiduciary Trust Company International, in New York. He cites the Fed's aggressive easing as a key reason. Materasso thinks the best play is in lower-quality bonds, which underperformed top-grade corporates last year.
Therefore, lower-quality bonds, depressed by recession fears that may prove overblown, have ground to make up. "You have to be very careful about the types of companies that you invest in, similar to investing in the equity market," Materasso says, noting that low-rated technology debt is not faring well now.
Of course, not all investors can stomach the credit risk inherent in any tier of corporate bond. Accordingly, the diminishing supply of Treasuries could send faint-hearted fixed-income investors scurrying to the mortgage-backed securities of the Government National Mortgage Association. Other than a Treasury, a Ginnie Mae pass-through is the only security that's backed by the full faith and credit of the United States government. And Ginnie Maes pay more-about 180 basis points more, currently. In a commentary he posted at www.pimco.com in May 2000, Pimco bond wizard Bill Gross predicted that Ginnie Maes will outperform Treasuries and return 8.5% over the next five-plus years. "You'll not find a better investment in the bond market" than Ginnie Maes, Gross wrote.
Not that these things are perfect, mind you. Ginnie Maes provide monthly income that's part interest and part tax-free return of principal-meaning they're self-liquidating instruments. "The trick is to separate the income from the principal and recycle the latter so that clients don't deplete principal," says Fort Worth advisor David Diesslin. Denver certified financial planner Larry Howes, with Sharkey, Howes & Javer, suggests using GNMA pass-throughs in trusts where the receipt of current cash is important but maintaining principal is less so.
A second drawback to Ginnie Maes is that, as with all mortgage-backed debt, they're susceptible to prepayment risk. That occurs when interest rates fall and homeowners decide to refinance, reducing the life and yield of the investment. To mitigate prepayment risk, the head of Diesslin & Associates Inc. suggests teaming pass-throughs with zero-coupon bonds. "That protects some of the upside if you think interest rates will go down," Diesslin says, explaining that the zeroes would appreciate even as the client receives early return of Ginnie Mae principal. "The unfortunate part is you've got double downside if you bet wrong on interest rates."
Ultimately, the prepayment risk makes Ginnie Maes less than ideal as the risk-free benchmark in a world without Treasuries. That leaves agency debt-the bonds, not the mortgage-backed securities, of the Federal National Mortgage Association (Fannie Mae) and the Federal Home Mortgage Corp. (Freddie Mac)-as possible heir to the throne of riskless security. Indeed, agency debt carries an implied government guarantee.
But that's the problem. It's widely perceived that the federal government wouldn't allow Fannie or Freddie to fail, yet no law requires Uncle Sam to rescue investors from agency default. Moreover, some on Capitol Hill have proposed weakening the ties between these highly-leveraged, government-sponsored, New York Stock Exchange-listed public corporations and Washington. "The reality is that as stand-alone credits, the agencies are not as creditworthy as they are as quasi-government entities," Seidner says.
The market agrees. When Rep. Richard Baker (R-La.) introduced legislation last year that would have removed the Treasury lines-of-credit available to the agencies (which have never been drawn on), their debentures cheapened dramatically. They've since rebounded, but that's merely another way of saying that congressional concerns have introduced a new source of volatility to the agency-debt market. "And if there is political risk, then I think it's hard for agencies to become the benchmark," says Seidner, who sees continued volatility in agency issues as the debate over these outfits' relationship with government proceeds.
Not everyone shares that expectation, however. David Glocke, who manages fixed-income portfolios for Vanguard, says the political risk associated with agency securities has abated, and therefore volatility will subside. Indeed, the latest bill from Baker's office (H.R. 1409, the Secondary Mortgage Market Enterprises Regulatory Improvement Act) seeks Fed oversight of Fannie and Freddie, a thrust seen as favorable for their securities.
If debt securities born in the United States won't make satisfactory benchmarks, what about the credits of other countries? "Some Euro-land type of government security could be there to come in," Materasso suggests. "If there is more unification, and if they decide to issue on more of an aggregate basis, then you have an economy that is as large as the U.S. economy and which could provide that type of pristine credit quality and access to capital. But I would put that as a low-probability event."
Materasso adds that even if that transpires, foreign debt still won't make sense for most American investors because currency risk would be part of the package. Moreover, the euro's disappointing debut is unlikely to ease investors' comfort level with these securities any time soon.
There's also the issue of whether American investors would view foreign-government debt as the same touchstone to safety that a Treasury is. Many would not, says advisor J. Michael Martin, president of Financial Advantage in Columbia, Md. "Americans typically don't think that another government is risk-free in the same way ours is," Martin says. "We're a pretty parochial bunch."
So some are buying Treasuries, despite the meager yield. "Maybe the supply will diminish to the point where the price of the bond goes up," posits Sam Hull of Northstar Financial Planning in Bedford, N.H., who has put a small portion of some clients' fixed-income allocations into Treasuries.
Certainly some investors will always demand the safety of the U.S. government-and there are plenty of not-for-profits, local governments and other organizations that, by charter, only can use Treasuries; combine a floor on demand with a shrinking supply, and Hull's investment thesis seems reasonable. In a worst-case scenario, U.S. governments could be added to a portfolio to net worry-free, below-market returns. "I call it a somewhat aggressive strategy," Hull says.
As far as the problem of a market sans risk-free security, Fed Chairman Greenspan isn't worried. "Given sufficient demand," Greenspan told the bond industry in April, "you or your colleagues could produce a nearly riskless security. For example, this could be accomplished with a very senior tranche of a collateralized debt obligation backed by high-grade corporate debt. I am confident that U.S. financial markets can (create) private alternatives with many of the attributes that market participants value in Treasury securities."
The transition wouldn't be painless, Greenspan said, but "competitive pressures and profit opportunities will provide a strong incentive to minimize such costs." For those wringing their hands about the disappearance of Treasuries, it's worth recalling that at one point during the 1960s, bonds issued by IBM sold at a yield below that of T-bonds with comparable maturities, meaning the market implicitly was saying that the computer giant was more creditworthy than the U.S. government.
Others, including Treasury Secretary Paul O'Neill, have suggested that the Treasury Department might continue issuing notes and bonds even if it were unnecessary to finance government activities. But the relative supply of T-bonds, bills and notes would likely be puny.
The bottom line is, if the Fed chief is right about budget surpluses knocking the Treasury market out of existence or shrinking it to a pool of capital no bigger than the California municipal market, the bond market is going to be one confused place for several years.