Bond Buyers Know It’s Time to Hang Up the Party Dress

In the free-enterprise system, everything is explained in one succinct phrase: supply and demand.

If I have something you want--and you want it badly enough--you’ll pay whatever I want to charge.

So it is with Beanie Babies, World Series tickets and, lately, U.S. Treasury securities.

The astounding decline in interest rates on Treasury bills, notes and bonds over the last few months is the result of panicked buying that has pushed those securities’ prices up dramatically.

With a bond that pays a fixed amount of interest, the ultimate yield will depend on the price you pay for that paper. A bond that generates $60 a year in interest, for example, will yield 6% if you pay $1,000 for it. If you want that $60 so badly that you’re willing to pay $1,200 for the bond, your “current” yield will be 5% ($60 divided by $1,200). And so on.

There are many reasons why Treasuries have rallied so powerfully, not the least of which is that investors worldwide are frightened out of their wits by the financial crises shaking the global economy. Fear raises the premium on certainty, and certainty is what a Treasury security provides.

The fall in yields, then, in large part reflects a demand for certainty. Those who don’t own that kind of certainty want it, and they’re willing to pay up to buy it from those who do.

Now, if only the Treasury could operate like any normal business that suddenly experiences unprecedented demand for its securities.

In Silicon Valley, they know what to do when investors can’t get enough of a hot new tech stock: They sell more shares at sky-high prices, which then allows the tech firm’s executives to buy $5-million homes, $80,000 cars and $150 GapKids outfits for their offspring.

The Treasury, if it was run by businesspeople, would be selling more bills, notes and bonds right now to take advantage of the demand--instead of allowing that demand to produce massive capital gains for the investors and Wall Street dealers who already own Treasury securities and are selling to those who don’t.

Of course, the government doesn’t need more money right now; it already has too much, based on the estimated $70-billion budget surplus achieved in the fiscal year ended Wednesday.

But Wall Street financiers might argue that the Treasury simply doesn’t understand the opportunities here. Sure, Uncle Sam doesn’t need the capital. So what? Raise it anyway, and use the proceeds for, say, a “strategic acquisition”--buy Canada, for instance, or maybe someplace warmer, like Costa Rica.

A much more serious proposal, it would seem, would be for the Treasury to use this plunge in yields to do whatever borrowing it still must do (which is a lot--the $4-trillion public debt just keeps rolling over, remember) via 30-year bonds instead of in the usual series of short-term and longer-term securities.

In other words, the Treasury would act like a lot of American homeowners who are refinancing their mortgages and lock in these current low rates for 30 years instead of borrowing shorter-term and risking that yields could rise again in the years ahead.

The Treasury, however, has long insisted that it can’t play the “yield curve,” as it’s called, because to do so could wreak havoc with investors’ expectations in what is the largest and deepest government securities market on Earth.

But there’s another reason why the Treasury might not want to lock in these long-term yields, including Friday’s new low of 4.84% on the 30-year T-bond: What if even these yields are far above what’s coming in 1999 and beyond?

That may seem incredible to ponder, but then, not long ago many investors were reluctant to buy Treasury bonds yielding 6% because that seemed like such a small return to accept.

Now 6% probably looks like an extravagant yield to investors who are all too willing to take 4.84%.

Will 4.84%, in turn, look rich six months from now?

There is a good argument that much of what is going on in the Treasury market is rank speculation--traders piling into bonds merely because they’re rallying, just as a lot of people were piling into stocks last spring because they were rallying, with little regard for the fundamentals.

But while that may be true on some level, the message in these record-low yields also may be that investors’ mind-set about what will constitute a “fair” return on investments in coming years is shrinking.

If inflation is going to stay around 2%, then a 4.8% yield on a risk-free bond is a “real” annual return of 2.8%--not a bad figure, historically.

If inflation is going even lower, or turns into deflation, then that real return would be even higher, though still in the low single digits.

Investors, of course, haven’t been accustomed to low-single-digit returns over the last 15 years. The blue-chip Standard & Poor’s 500-stock index has returned roughly 17% a year in that period. The average U.S. long-term bond fund has returned almost 10% a year, according to Lipper Analytical.

It has been a phenomenal party. But as William Dudley, financial markets economist at Goldman, Sachs & Co. in New York points out, “This isn’t normal.” Going forward, he says, “we’re going to have to learn to live with smaller returns”--he suggests perhaps 5% or so on long-term bonds and 8% or so on stocks, as low inflation, cutthroat business competition worldwide and long-lasting effects from this year’s global crises weigh on governments, companies, and investor and consumer psychology.

That means the stock market would rise 8%, year after year? Unlikely. It means that over 10 years, with a lot of volatility (read: risk) your ultimate annual return might work out to about that.

Maybe that’s too pessimistic. But if bond investors continue to ratchet down their return expectations, isn’t the implicit message that stock investors must do the same?

Tom Petruno can be reached by e-mail at tom.petruno@latimes.com.

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Ever Smaller Numbers

The yield on the 30-year Treasury bond, a benchmark for other long-term interest rates, has tumbled to its lowest level since at least the late 1960s. Quarterly closes and latest:

1998, Friday: 4.84%

* Source: Bloomberg News