Treasuries sneak quietly into favor

Even as the equity markets show little evidence of slowing down, the 10-year U.S. Treasury has been quietly telling a different story, with the yield falling more than 20% from the start of the year. Financial advisers and market watchers offer mixed reviews on what might be driving the rally, as bond prices move in the opposite direction of bond yields. But it is clear there is a steady appetite for the world's safest asset class. “It is a bit of an anomaly and it looks strange to have the yield falling, because at the start of the year most expectations were for it to go up 50 or 60 basis points,” said Lon Erickson, manager of the Thornburg Limited Term Income Fund (THIIX). The 10-year Treasury yield, now hovering around 2.4%, has been falling all year from its Dec. 31 peak of 3.03%. What is most surprising about the 2014 run, which would normally suggest some kind of risk-off mood from investors, is that it is happening while the S&P 500 Index is enjoying an 8% rally from the start of the year. For financial advisers, this kind of dual rally has required a deeper dive into the macroeconomic and geopolitical spectrum to try and justify allocations in or out of Treasury bonds. “We've been out of all bonds for two years, and we're not even getting close to them because next year the Fed is going to start raising interest rates,” said Theodore Feight, owner of Creative Financial Design. “We expect interest rates to increase substantially, to 4% or 4.5% over the next 12 months. “Right now people are taking the safety of Treasury bonds over everything else,” he said, “but they don't understand how much risk they're taking on.” Paul Schatz, president of Heritage Capital, has a different take. “Our global macros strategy has had a 40% weighting in U.S. Treasuries all year,” he said. “We're looking at long-term slow growth and low inflation, with a whiff of deflation, and that benefits Treasuries.” Mr. Schatz gains exposure to Treasury bonds through the Rydex Government Long Bond 1.2X Strategy (RYGBX) and iShares 20+ Year Treasury Bond (TLT). “This trade may end next week or next year, but it has been a really profitable low-volatility trade,” he said. Even with such a heavy allocation to Treasury bonds, Mr. Schatz feels comfortable that the yield will hover between 2.25% and 3.25% leading up to the next recession, sometime within the next two years. At Alpha Capital Management, director of research Anna Dunn admits she has been surprised by the Treasury bond rally. “We've been thinking yields were going to rise and we've positioned our portfolios for that,” she said. Part of the push behind the yield decline, she added, is likely tied to “a lot of frightening news and the basic macroeconomic environment. “The fixed income market is at a scary point right now and Treasuries are a default move for a lot of investors,” she said. “If you don't know what to do in bonds, go to Treasuries. If the stock market looks too high, go to Treasuries.” The default-move theory is where most of the consensus can be found. “You have to consider all the global appeal of U.S. Treasury bonds right now,” said Wilmer Stith, co-manager of the Wilmington Broad Market Bond Fund. “Globally, our Treasury yields are still significantly higher than other places around the world,” he added, citing a 50-basis-point yield on comparable Japanese bonds, and a yield of less than 1% on comparable German bonds. Robert Tipp, chief investment strategist at Prudential Fixed Income, said the Treasury yield slide was part of his forecast for the year and he now believes the 10-year will likely be yielding around 2.7% by the end of the year. “Sometimes Treasury bonds have a value as a hedge against risk, but sometimes the yield can be impacted by Fed buying,” he said. The Federal Reserve Board of Governors, which is meeting this week for its annual gathering in Jackson Hole, Wyo., is expected to start raising short-term interest rates at some point next year. But for most Treasury-bond investors, that's an arm's-length concern, at best. “The Fed will raise rates next year, and the short-term rates will probably go back toward 1%,” said Mr. Schatz. “But that will probably have minimal impact on the 10-year, because the yield curve is so steep right now.”