The fact that U.S. Treasury bonds managed to cling to their coveted triple-A rating this week failed to impress several prominent bond fund managers, who say they are lightening up on Treasuries and stocking their portfolios with corporate bonds instead.
Despite the debt ceiling deal, U.S. sovereign debt remains in the crosshairs of ratings agencies like Moody’s and Standard & Poor’s. The rating agencies remain concerned that the U.S. is “not doing enough to reduce spending and/or increase revenues to bring down the trajectory of the country’s mounting debt,” warns BlackRock’s head of fixed income portfolio management, Peter Fisher, in a report issued earlier this week. If the U.S. were to be downgraded by one or more agencies, he observes, “the odds are very high that there would be knock-on consequences of other borrowers getting downgraded — both corporate and public, in the U.S. and overseas.”
Robert Persons, who manages the MFS Bond Fund, believes corporate America is replacing Uncle Sam as the borrower with the strongest financial profile. He exited U.S. Treasury debt nearly two years ago and has not returned since; he asserts government bond yields are so low that the risk of investing in them just isn’t worth it.
“Companies are the ones who have fixed their balance sheets, cut costs, and generated higher cash flows,” he says. “It’s the public sector that’s dropped the ball and left taxpayers to pick up the tab.”
Even before all the debt drama unfolded, many bond fund managers weren’t enamored with U.S. Treasury bonds because of their historically low yields, which are currently hovering at about 2.6 percent for the 10-year bond.
The average intermediate-term investment grade bond fund has about 14 percent of its assets in Treasury securities, according to Lipper — less than half the 32 percent weighting in that sector for the Barclays Capital U.S. Aggregate Index, a benchmark for U.S. investment-grade debt.
A number of fund managers with the flexibility to pick their spots in the bond market had little or no exposure to Treasury securities before the debt debacle, and have no plans to up the ante any time soon.
Pimco bond guru Bill Gross, the most visible and vocal of U.S. Treasury debt detractors, reiterated his disenchantment with the group in a report posted on the firm’s web site this week. The manager of the $243 billion PIMCO Total Return Fund, the largest bond fund in the country, drastically reduced the fund’s exposure to U.S. government debt earlier in the year and exited the market completely in March.
“The current Congressional compromise is but one small step for fiscal solvency,” Gross says. “There is no giant leap for mankind anywhere on the horizon.” Instead of U.S. Treasuries, the fund is using a mix of mortgage-backed securities, investment-grade corporate bonds, emerging market bonds and cash equivalents.
“Even if you don’t consider default risk, a very small price drop because of an increase in rates could easily wipe out a year’s worth of coupon on a new 10-year Treasury,” Persons says. “That’s a pretty daunting prospect. And yields of less than four percent for 30-year bonds present a pretty pessimistic view of the world.”
Although many investors still view Treasury bonds as a safety haven, Persons believes a ratings downgrade could raise borrowing costs for the country and depress bond prices. “Because of their debt problems and ratings downgrades, borrowing costs in Spain and Italy went from 3.5 percent to over 6 percent in a matter of months,“ he says.
He believes U.S. corporate bonds represent a better value and offer better yields, and are less susceptible to interest-rate shocks than Treasuries. MFS Bond Fund has about half of its assets in corporate bonds rated triple-B, the lowest investment-grade rating, and another 26 percent in bonds rated just below investment-grade. Persons is banking that the latter group would get a pricing boost if they move into investment-grade territory.
Jason Brady, who manages several bond funds for Thornburg Investment Management, prefers investment-grade corporate bonds and mortgage-backed securities over Treasuries because they represent a better value and offer higher yields. One of the funds he manages, the Thornburg Limited Term Income Fund, has just 2.7 percent of its assets in Treasury securities and 55 percent in corporate bonds.
“It makes sense to take marginally greater risk to get notably better income,” he says. “And the fact is, corporate balance sheets look better than the government’s balance sheet right now.”
At the same time, Brady doesn’t think a ratings downgrade would be the disaster for the Treasury market that some experts predict. “The rally over the last few days makes it pretty clear that people still view Treasuries as a flight-to-quality investment, regardless of their rating,” he says. “The Treasury market is one of the largest and most liquid in the world, and the U.S. still has the capacity and willingness to pay its debts.”