By Dakin Campbell
Dec. 1 (Bloomberg) -- In the best year for Treasuries since 2002, fund managers who only buy government bonds are seeking permission to invest in corporate debt they considered toxic just a month ago.
Treasuries “are yielding next to nothing,” said Robert Millikan, who manages $5 billion at BB&T Asset Management in Raleigh, North Carolina, including the $51 million BB&T Short U.S. Government Fund. “Trying to do something for yourshareholders, it’s hard to sit there and buy a bond that yields less than any fees you charge.”
While U.S. government debt returned 10.1 percent on average this year, the most since 11.6 percent in all of 2002, Merrill Lynch & Co. index data show, yields dropped so low that fund managers have little chance of offering anything but subpar returns in 2009. Yields on two- and 10-year notes, as well as 30-year bonds fell to record lows today.
That helps explain why BB&T, BlackRock Inc., T. Rowe Price Group Inc. and Sage Advisory Services Ltd. are looking elsewhere for returns, including bonds of the banks that were almost ruined by $967 billion in losses and writedowns since the start of 2007. Treasury funds are receiving permission to buy debt of Morgan Stanley, JPMorgan Chase & Co. and Goldman Sachs Group Inc. after the Federal Deposit Insurance Corp. finalized plans on Nov. 21 to guarantee their debt.
The FDIC program announced on Oct. 14 is part of the more than $1.5 trillion in unprecedented financing from the Treasury and the Federal Reserve to end the worst financial crisis since the Great Depression. The U.S. now guarantees more than $13 trillion of debt.
Goldman First
Goldman, which registered as a bank in September after 139 years as a securities firm, became the first U.S. company to take advantage of the program, selling $5 billion of 3.25 percent FDIC-backed notes on Nov. 25. The debt, which matures June 2012, was priced to yield two percentage points more than Treasuries of similar maturity. Before the government announced the guarantees, New York-based Goldman’s 6.15 percent bonds due 2018 yielded about five percentage points more than government debt.
Morgan Stanley, which also became a bank on Sept. 21, sold $5.75 billion in FDIC-backed debt in three series, including $2.5 billion of three-year, 3.25 percent notes at a spread of 186 basis points. As recently as Oct. 13, the New York-based company’s notes yielded more than six percentage points more than Treasuries.
‘Why Buy?’
“It’s a great substitute,” said Millikan, whose Short U.S. Government Fund returned 4.55 percent the past year, beating 78 percent of its peers. He gained approval from BB&T’s lawyers to purchase FDIC-backed debt and may buy bonds from New York-based Citigroup Inc. and Bank of America Corp. in Charlotte, North Carolina.
Two-year note yields fell 11 basis points last week to 1 percent as reports showed gross domestic product shrunk 0.5 percent in the third quarter and Americans cut spending by 1 percent in October, the biggest drop since the last recession in 2001. The price of the 1.25 percent security due November 2010 rose 6/32, or $1.88 per $1,000 face value, to 100 16/32 since being auctioned on Nov. 24, according to BGCantor Market Data.
The yield fell five basis points to a record low of 0.9251 percent at 10:25 a.m. in New York.
“There are plenty of cheap quasi government-guaranteed alternatives to Treasuries,” said Stuart Spodek, co-head of U.S. bonds in New York at BlackRock, which manages $502 billion in debt. “So why buy a two-year note?”
Barely Above Fees
The hunt for alternatives to government debt may become more acute because the Fed is likely to cut interest rates to less than 1 percent this month.
Futures traded on the Chicago Board of Trade show a 76 percent chance Fed policy makers will cut the 1 percent target rate for overnight loans between banks by 50 basis points at their Dec. 16 meeting. All other bets are for a reduction of 75 basis points, or 0.75 percentage point.
If the federal funds rate falls to 0.5 percent and two-year Treasury note yields follow, investors would realize an annualized return of 1.5 percent, according to Bloomberg data. That would barely cover the 0.66 percent expenses charged by Millikan’s fund.
JPMorgan Forecast
Yields will decline in 2009 as the Fed lowers its key rate to zero from 1 percent, JPMorgan Chase & Co. wrote in a report on Nov. 28. Two-year yields will fall to 0.6 percent by June 30 while 10-year yields tumble to 2 percent, JPMorgan said.
The FDIC guarantees opened credit markets for banks shut out of long-term financing alternatives. Yields on investment- grade financial debt rose more than 5 percentage points this year to a near-record high of 7.28 percentage points above Treasuries, according to Merrill Lynch index data. Investment- grade bonds are debt rated Baa or above by Moody’s Investors Service or BBB or above by Standard & Poor’s.
As much as $600 billion of the FDIC-backed bonds may be issued by the time the program ends in June, according to Barclays Plc. Such sales already total $17.25 billion.
That’s on top of $1.7 trillion of securities sold by government-chartered mortgage finance companies Fannie Mae in Washington and Freddie Mac of McLean, Virginia, $1.3 trillion of bonds from the 12 Federal Home Loan Banks and almost $5 billion in agency mortgage securities.
‘Safe Instrument’
“A lot of Treasury-only funds will be looking at” FDIC- backed notes, said Brian Brennan, who helps oversee $13 billion in fixed-income assets at T. Rowe Price in Baltimore. “For investors who are seeking safety, this is a safe instrument that provides more yield.”
Brennan’s U.S. Treasury Intermediate Fund returned 9.27 percent in the past year, beating 99 percent of its peers, according to data compiled by Bloomberg.
Government debt rose 5.38 percent in November, the most since Ronald Reagan was in the White House in 1981, even as demand for company bonds increased. Investment-grade corporate debt returned 3.6 percent, the best performance since September 2003, after falling 15 percent the previous 10 months.
There’s little chance that demand for Treasuries will slacken as investors seek a haven from riskier assets, said Ian Lyngen, an interest-rate strategist in Greenwich, Connecticut, at RBS Greenwich Capital. The firm is one of the 17 primary dealers of U.S. government securities that trade with the Fed and are obligated to bid at the Treasury’s auctions.
‘Marginal Impact’
FDIC-backed bank debt “will have a marginal impact, if any,” said Lyngen, who expects two-year Treasury yields to decline to 0.85 percent in the first quarter. “It’s a bit of a toss up given that the bulk of the move has been a flight to quality.”
The FDIC program follows more than a dozen government programs to unlock credit that will be paid in part with Treasuries. Gross issuance in the $5.7 trillion Treasury market will increase to about $1.2 trillion in fiscal 2009, which started on Oct. 1, from $724 billion last year, according to Credit Suisse Group AG, another primary dealer.
President-elect Barack Obama pledged during a Thanksgiving address to forge a “new beginning” from the moment he takes office and said his economic team is already working on a recovery plan.
Obama said he will name New York Federal Reserve Bank President Timothy Geithner as Treasury secretary and Harvard University Professor Lawrence Summers, a former leader of the Treasury as White House economic adviser. He also appointed former Fed Chairman Paul Volcker as head of an economic recovery advisory board.
The risk for investors now is that the combination of more government bonds and guaranteed debt will make Treasuries less desirable.
“Treasury rates are going higher,” said Mark MacQueen, a partner and money manager at Austin, Texas-based Sage Advisory, which oversees $6 billion. “I plan to invest in the guaranteed debt.”
To contact the reporter on this story: Dakin Campbell in New York atdcampbell27@bloomberg.net
