We believe that it may be prudent for investors to take profits in Treasuries as T-Bond interest rates have nowhere to go but up. We were surprised that the Federal Reserve’s easy money policies have pushed the 10-Year U.S. Treasury note interest rate from 6.58% at the beginning of 2000 to 2.64% as of September 2013. The Federal Reserve’s easy money policies have been able to drastically reduce the interest rate on Treasury securities considering that the total amount of Treasury debt outstanding has nearly tripled from $5.7 Trillion at the end of the U.S. Government’s fiscal year 2000 to $16.7 Trillion at the end of fiscal year 2013.
Source: U.S. Treasury
Although the projected U.S. budget deficit of $642 Billion in fiscal year 2013 is half of the $1.3 Trillion deficit in 2009, it is still 40% higher than the $459 Billion deficit incurred in 2008. Furthermore, the debt has increased by 67% in the last five years.
The 10-Year Treasury Interest Rate bottomed out at 1.66%. Since then, it has consistently increased and is now at 2.64% due to concerns that the Federal Reserve would begin to taper its purchases of Treasury securities. Although the Federal Reserve decided not to begin tapering its purchase of Treasury securities in September, we believe that 10-Year interest rates will not retest the sub-2% levels seen earlier this year for a number of reasons. We believe this even though Federal Reserve Vice Chairman and well-known inflation-dove Janet Yellen is the leading contender to replace Ben Bernanke as the Federal Reserve Chairman. We expect that political gridlock due to the debt-limit fight as well as the funding of the government will serve to potentially lift interest rates further and undermine investor confidence.
We are also aware that interest rates on government bonds have been rising throughout the G7 countries. We disagree that this is due to stronger economic growth forecasts; we believe that this is due to the steady expansion of government debt in these countries. We noticed that the European Central Bank might attempt to combat this by cutting interest rates in the Eurozone however; we see that as attempting to put a Band-Aid on the Eurozone economies instead of moving those countries forward towards fiscal responsibility.
Unless the federal government was to engage in significant fiscal reforms, we believe that 10-Year Treasury rates will continue to increase, especially due to the government shutdown. Many corporate borrowers have stepped into the bond market in order to take advantage of historically low interest rates. Verizon Communications raised $49 Billion in order to finance its acquisition of the 45% stake in Verizon Wireless that it does not already own from Vodafone. Apple Inc issued $17 Billion worth of debt in May even though it has $144 Billion in cash and liquid investments in order to finance share repurchases and dividend growth. Corporate borrowers issued $193.7 Billion in new corporate bonds in September 2013. This broke the previous monthly bond sale record of $177.3 Billion set in September 2012.
In conclusion, we expect interest rates on government debt to continue increasing. We recommend that borrowers should be looking to engage in timely refinancing of their debt as well as locking in historically low borrowing costs in order to avoid potential interest rate increases. We recommend that fixed income investors continue to focus on high quality credits as well as high-yield credits that offer a strong risk-reward opportunity. For investors that must be exposed to the fixed income markets, we recommend shortening duration at the margin by replacing maturing assets with low duration securities as well as steadily replacing long-duration securities with short duration securities. This way, investors will reduce the likelihood of seeing large potential principal losses on their bonds and will avoid suffering through a low interest rate for a long time-period on its old bonds when newer bonds are paying higher interest rates.
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Disclosure: Analyst(s) publishing this report is short the TLT.
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