Treasury holders face potential 34% loss of capital in yield reversion

Investors in the ‘safe haven’ of 10-year Treasuries will lose one third of their capital if yields on the debt returns to its 50-year average of 6.5%, according to Jan Dehn, strategist at Ashmore Investment Management.

This is not a less severe than the 53.5% haircut Athens wanted some of its private sector creditors to take on the value of its loans, but Dehn says the overall cost to Treasury investors of their ‘safe holdings’ losing value could be higher.

Dehn says the greatest risk to the world’s debt investors is managing the coming rise in US Treasury yields, from below 1.8% currently to the long-term average of 5%, or 7% if the period 1980-1985 is included when yields briefly hit 15.8%.

In other words, investors’ greatest risk is not managing European periphery exposure, where arguably most of their attention is focused.

Data from Barclays shows European holdings of US Treasuries expanded 67% to nearly $450bn since May 2011.

Dehn says: “This should concern everyone. Liquidity depends on the existence of both buyers and sellers. If heavily indebted developed countries’ bond yields unhinge much more, paper has to exit via a smaller door.”

His research shows the inherent danger of investors – including pension funds and insurance companies as stewards of individuals’ retirement savings – being pushed towards the safe havens of Treasuries, and European core government debt at similarly low yields.

“This risk is potentially many times costlier than a Greek default. It is a risk which investors should not ignore.”

He attributes low yields on core debt to safety-seeking, and to the Federal Reserve, European Central Bank, Bank of England and Bank of Japan engaging in “unprecedented money printing via Quantitative Easing” during a period of ultra-low interest rates.

“But US consumers are gradually deleveraging. Europe’s policy makers are turning away from austerity and towards more growth. Central Bankers are already becoming more reluctant to support the market with additional stimulus, wary not just of the dangers of stimulus addiction, but also of the ever-increasing risk that a significant inflation premium creeps into long-term bond yields.

“There is no precedent for reversing QE of the magnitude currently in place. At best, when the time comes for reversing the current set of policies, the market will therefore price in a material risk of policy mistakes. Not only may yields rise, they will also become more volatile.

“Rate volatility in turn will end the phoney war in currencies; FX markets will become extremely unstable too. FX weakness and higher rates will both work against holders of heavily indebted developed countries’ bonds.”

Dehn advocates emerging markets local currency fixed income investments as a form of hedge against such dangers.

Other alternatives such as hedging interest rates directly, by shorting Treasury futures or receiving floating legs of swaps contracts, shortening duration, or buying equities are not available to all buyers.

“Long-only fixed income investors must try to find less rate sensitive assets, such as perhaps counter-intuitively higher spread bonds, or bonds with entirely different yield drivers.

“Typically, this means markets with materially different bases of investors. On both these premises, emerging market local currency government bonds look attractive.”


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