Why Treasury Bonds Look So Risky Right Now

It's more than just "low" yields, says Morningstar's Eric Jacobson

Eric Jacobson 16 April, 2012 | 9:04AM
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Even before last summer's big Treasury bond rally, there was buzz in the financial press about the question of whether we were in a bond "bubble." With yields having fallen even further since then--and even factoring in an uptick during the first quarter of 2012--there's still a palpable sense among market participants that something about Treasury bond yields just isn't right. Back in February, the CEO of BlackRock, one of the market's largest bond managers, famously told Bloomberg News that "investors should have 100% of investments in equities because of valuations and higher returns than bonds."

Much of the talk until recently has simply focused on how low Treasury yields have gone. They sounded low to many people when the 10-year note was at 3.5% in early 2011, and a majority of core bond-fund managers kept their funds' interest-rate sensitivity short of the Barclays U.S. Aggregate Bond Index over the course of the year. In the wake of the summer 2011 rally, though (and even after the first-quarter 2012 spike), the 10-year yield looks "really" low at 2.3%.

What does it mean, though, to say that yields are low? Well, one relatively simple way to view a bond's yield is as compensation for holding it over a set period of time. The idea is that one can theoretically deconstruct that yield into compensation of different types depending on the kind of risk an investor is taking on. At a high level, many investors think about it as a split between the amount necessary to compensate for inflation and then everything else grouped together as the so-called real yield. For a typical municipal bond, for example, one might expect to be compensated for the risks of inflation plus various different amounts for risks associated with liquidity, credit quality, call features, and the term of the bond. Having a framework around which to understand how much bonds of different kinds ought to compensate investors is a crucial task for any active bond-fund manager. Each of those risk components may deserve to be larger or smaller at various times, and it is a manager's fundamental task to judge those levels and to either buy or sell bonds depending on whether they're providing enough value.

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Eric Jacobson  is director of fixed-income research with Morningstar.