By Deborah Levine
NEW YORK (Dow Jones) -- A decade of falling prices is perfectly
plausible to at least one very successful investor, so he's
sticking with long-term Treasury bonds.
Lacy Hunt, an economist and fund manager at Hoisington
Investment Management in Austin, Texas, is convinced that once an
economy goes from a period from extreme over-indebtedness to
falling prices, as the U.S. has now, it ushers in a decisive shift
in markets.
And in the U.S. case, bond bulls say, the high levels of debt
held by government, businesses and consumers will spell the
nation's undoing.
"Once we start a debt deflationary event, historically they tend
to be very pernicious," said Hunt, who helps oversee the
Wasatch-Hoisington U.S. Treasury Fund (WHOSX), which returned
almost 38% last year. The fund has 10-year annualized gains of
7.56%, making it the best performing long-government bond fund over
that period, according to Morningstar.
"There are no quick fixes here, so we're in long Treasurys,"
said Hunt, whose fund manages about $4.5 billion in assets.
That strategy goes along with the expectation of some economists
that falling housing prices will continue pressuring other parts of
the economy. If a true deflation trend takes hold, the value of
bonds increases because they have fixed coupon payments.
Indeed, deflation is anything but a threat to bond investors.
Their cardinal rule is that one of the biggest risks of holding
fixed-income debt is that inflation will erode their value.
Yields on 30-year bonds (UST30Y), currently at 3.55%, could fall
to 2%, but it will likely take more than a decade, in Hunt's view.
As yields fall, prices move in the opposite direction and
strengthen, which would benefit bond holders like Hunt.
As much as the government is trying to steady financial markets
and encourage lending, stimulus in the system isn't flowing through
to consumers, said William Bellamy, who manages about $1 billion as
director of fixed income at Thompson Siegel & Walmsley.
And with the job market as weak as it is, wages -- a key
component of business costs -- are likely to remain subdued, a
trend that allows companies to lower their prices.
"I'm in the deflation camp because it could take a while," said
Bellamy, co-manager of the TS&W Fixed Income fund (TSWFX). "The
only way for prices to go is down."
Flipping to inflation
Still, there are plenty of strategists and investors who expect
deflation over the next several months, but not long enough to
merit going whole hog into Treasurys.
"It's entirely likely we'll have some sort of mild deflationary
period of the immediate coming quarter," said Christopher Sullivan,
chief investment officer at United Nations Federal Credit
Union.
Personal consumption has dropped off, and is likely to remain
that way or decelerate further, he said. That will set up a domino
effect, because "there isn't any pricing power, so businesses will
want to conserve market share and cut prices to work down excess
inventories."
Certain costs, including rental housing and health care, have
held up, and the government's stimulus plan is likely to spur
economic growth at some point, even if not this year, Sullivan
said.
"The market is expecting we'll be back to inflationary concerns
in the coming years," he said.
One way for bond investors to protect themselves against rising
inflation is to buy Treasury Inflation Protected Securities, which
explicitly pay holders the government's rate of inflation in
addition to a coupon.
TIPS, however, have sold off dramatically in recent months as
some investors dumped them in favor of more liquid, regular
Treasurys. That's shrunk the gap in yields between TIPS and regular
Treasurys of the same maturities, used as an indicator of
investors' inflation expectations.
Ten-year TIPS currently yield about 1.11% percentage point less
than regular 10-year notes (UST10Y), meaning the price is
relatively cheap for someone who expects inflation to top that over
that time horizon.
Still, those low expectations and signs of deflation this year
are unlikely to convince many that Treasurys are a good investment
right now for the long term.
Riskier assets
If the economy is even weaker than currently expected, deflation
may continue, said Michael Pond, a Treasury strategist at Barclays
Capital. Still, the slowing growth would be the main catalyst for
investors to shift to Treasurys from riskier assets, including
equities and other types of bonds.
"A weakening economy, rather than deflation fears, would be the
primary driver of other asset classes," he said.
Moreover, steps by the Federal Reserve and the government to
stabilize the financial system have flooded the markets with
liquidity, which tends to be inflationary.
"It may be difficult to remove the foot from the accelerator
when they should," Pond said. "Officials are much more concerned
about the downside risks to growth," so they may leave the stimulus
in place a little longer just to be sure a recovery has taken hold.
"The risk of the Fed and fiscal policy creating inflation down the
road has increased, so the market should price in that risk."
Investors more concerned about inflation are likely to get out
of Treasurys all-together, probably in favor of corporate bonds,
Bellamy said.
"You'd want to get on the credit side of things and into the
high-yield sector to have some cushion from inflation," he
said.
Speculative-grade debt, also known as junk bonds, currently
yields about 14 percentage points more than Treasurys, according to
Standard & Poor's.
"In the near-term, the greater risk is deflation and the Fed is
reacting to that," Pond said. "Longer term, more than several
months out, the market should be pricing significant risks of
inflation."