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Treasuries May Not Be the Answer, Some Warn

July 24, 2002|DEBORA VRANA | TIMES STAFF WRITER

Yields on two-year and five-year Treasury notes plunged Tuesday to their lowest levels in a generation, as more investors rushed into government bonds amid the stock market's continuing slump.

But as returns on Treasury securities dwindle, many experts warn that investors may be underestimating the risks.

The concern isn't about the safety of interest payments or principal repayment, because there's no question the government will make good on what it owes.

But if or when market interest rates reverse, the market value of Treasuries bought at today's prices and yields would tumble. That could mean losses for investors forced to sell before the securities mature, or for investors holding bond mutual funds filled with Treasuries.

"Absolutely, when you are down at these low yield levels, investors could get beat up pretty good" if rates reverse, said Bob Auwaerter, senior fixed-income manager with mutual fund giant Vanguard Group, in Valley Forge, Pa.

So far, those risks aren't deterring many investors: On Tuesday, the yield on the two-year T-note dived to 2.24% from 2.34% on Monday, as investors snapped up the notes.

The closing yield Tuesday was below the previous low of 2.3% set in November and is the lowest since the government began regular sales of two-year notes in the 1970s.

Likewise, the five-year T-note yield on Tuesday also fell below its November low, ending at 3.46%, down from 3.56% on Monday.

Some analysts say Treasury buyers today may be betting that the economy will fall back into recession, causing the Federal Reserve to cut short-term interest rates from what are already 40-year lows. If that happens, yields on Treasuries could fall much further, some experts say.

But if the economy remains in recovery mode, and once the stock market bottoms out, a big question is whether many investors will quickly abandon Treasuries for better returns in other securities, causing yields to whiplash.

That happened earlier this year: After plunging to what were then generational lows in November, Treasury yields surged in the first quarter. The five-year T-note yield rose from 3.47% in November to 4.84% by March 28.

Auwaerter said an investor buying a five-year T-note yielding 3.45% on Tuesday could see the price of the note drop by 4% if market interest rates rise 1 percentage point in the next 12 months.

The lower the yield, the greater the vulnerability to interest rate swings, analysts said.

"It's hard to recommend that people invest in government bonds, given that we've got some of the lowest yields," said Ashok Bhatia, portfolio manager of a $2.4-billion government bond fund for Strong Funds in Menomonee Falls, Wis. "But it's still going to beat a lot of other investments out there," he said.

"There are very few places investors feel safe right now," said Bob Gahagan, who heads the $8-billion taxable bond division for American Century Investments in Mountain View, Calif. "Government bonds are a place where credit quality is the highest. People are looking for safety, regardless of the yield."

Still, the timing for investors on the run from stocks may not be ideal.

To lower the risks, portfolio managers like Auwaerter recommend that investors stick with short- or intermediate-term bond funds because longer-term funds could be hurt the most if interest rates reverse.

"A lot of people think government bonds are guaranteed," Auwaerter said. "Their credit quality is, and there is a low default risk, but they have a potential interest rate risk."

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