US Treasuries likely to burn investors, warns Loomis Sayles

Portfolio manager Kenneth Buntrock believes credit is still the best place to be in US fixed income.

Bond house Loomis Sayles predicts the US Federal Reserve Bank will raise the fed funds rate in the third quarter of 2010, which should drive yields on the 10-year Treasury from the current 3.5% level to around 4.25% by the end of next year.

"That probably means the price of Treasuries will eat away at the coupon, which could result in a negative return," says Kenneth Buntrock, Boston-based vice-president. Other US market participants have stated similar concerns.

He expects trading in US Treasury bonds to remain within a range, despite fears of the economy tipping back into recession, because inflation remains virtually nil right now.

Loomis Sayles maintains only short-duration exposure to Treasuries -- its duration exposure is to corporate credit. If market expectations of a Fed interest-rate hike prompt a more immediate exit among investors and yields rise to 4.25% by June, Loomis Sayles would consider this a time to get into longer-dated bonds.

But Buntrock doubts there will be such a rise of interest rates in the first half. "Investors are scared of all the supply of G4 debt that is coming," he says, "But until consumer bank lending resumes, we're unlikely to see a meaningful rise in interest rates." [The G4 includes the US, UK, eurozone and Japan.]

US credit option-adjusted spreads are around 200 basis points above commensurate Treasuries right now. The 10-year mean for such an average is 174 basis points. So Buntrock reasons there is still some tightening to go, in both investment-grade and high-yield bonds.

In terms of yield, a blended average of US corporate credit is more attractive for investors than Treasuries. Investors want yield, so will favour credit markets, Buntrock adds. Meanwhile, corporate balance sheets are generally in strong shape.

He cites China as a possible risk. "China has done the world a service with its stimulus measures," he says. "If that were to falter, it would affect other economies."

Another risk of being overweight credit versus Treasuries is if developed markets raise interest rates sooner than investors expect. Central banks in the G4 have, however, attempted to convey their determination not to do so.

Further down the road, Buntrock says the US will eventually import inflation from China. China's fixed-currency regime means it has adopted US monetary policy, which is so loose that it will spur inflation. In the US, balance sheets are so tattered that inflation will take time to gain traction, but it will happen more quickly in China. That will lead to price rises that feed into the US via trade.

Down the road this could force the US to become more hawkish in its monetary policy -- but that is a concern for another day. For now, at all levels along the yield curve, investment-grade credit yields are more attractive than Treasuries, from a 224bp pickup on the two-year to 189bp over the 10-year. That's where Loomis Sayles intends to make its bets as 2010 progresses.

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