U.S. Treasury Bonds: Between a Rock and a Hard Place

May 5, 2011

In a recent newsletter, Bill Gross (the Chief Investment Officer of PIMCO, one of the largest and most prestigious bond-management firms in the U.S.) highlighted the following three important points:

  • The U.S. federal deficit has exploded to $1.5 trillion since the financial crisis and seems unlikely to decrease anytime soon;*
  • Deficits are generally financed through government-bond issues (also known as “Treasury Bonds” or “T-Bonds”);
  • In the last year, 70% of new T-Bonds were purchased by none other than the U.S. Federal Reserve, a transaction that equates to printing money to finance the deficit.

On the one hand, the U.S. government is spending beyond its means and piling up record-high deficits to compensate for weak demand from the private sector and to ward off a recession. On the other hand, the Federal Reserve is buying massive amounts of Treasury Bonds in order to drag down interest rates and stimulate the economy. This double economic electroshock cannot be sustained for long.

When the Federal Reserve purchases T-Bonds, it increases the money supply and, therefore, it will ultimately have to reverse these purchases; otherwise, inflation will likely spike somewhere down the road. Whether or not it does, it is likely that yields will rise as a result of either:

  • An increase in the required interest rate, to compensate for inflation, or
  • A premium to entice new investors to buy T-Bonds instead of the Fed.

While we don’t believe that Mr. Gross can forecast the future any better than anyone else, his comments highlight a risk that is pertinent for Canadian investors: rising T-Bond yields (which result in price drops) are a distinct possibility. If U.S. yields rise, there is a chance that Canadian bond yields will follow. This is why PWL is keeping bond maturities quite short in general: rising yields cause far less damage to short-term bonds than to their long-term counterparts. But even better, the holders of short-dated bonds can benefit from rising yields by reinvesting the proceeds at maturity at higher rates.

* By comparison, the Canadian federal deficit is less than one-third that of the U.S., after adjusting for population size.

Raymond Kerzérho

Chairman of the Investment Committee
and Director of Research
PWL Capital Inc.