Get Over Treasuries
Uncle Sam's IOUs are still safe, but you can find better yields from other investments.
Standard & Poor’s downgrade of long-term Treasury debt to AA+ is an embarrassment to the U.S. and the latest challenge to our economy’s reputation for resilience. However, bond investors shouldn’t get in a tizzy over the rating agency’s move. Putting aside the extraordinary jump in Treasury bond prices (and the concurrent drop in yields) immediately after the downgrade, a result of flight-to-quality buying by panicked investors, you shouldn’t expect major moves in bond prices and yields in the coming months.
S&P did not consign Treasury bonds to the garbage pile or question the bedrock principle that the U.S. backs its bonds with the full faith and credit of our government. The downgrade is not a warning that the U.S. Treasury won’t be able to pay its bills or that it will have trouble borrowing money. An AA+ rating shows a “very strong capacity to meet financial commitments,” while AAA is “extremely strong,” according to S&P. More to the point, the Treasury, in partnership with the Federal Reserve, can create dollars or borrow from the rest of the world in U.S. currency. Swiss, German and Canadian bonds are having a wonderful run, but there aren’t enough of them and other triple-A-rated alternatives to soak up all the money in search of safe, liquid income investments.
Governments, banks and insurance companies may still consider Treasuries, even with an AA+ rating, the globe’s best repository for their reserves, but government bonds aren’t as appealing to individual investors. In fact, savers have been disenchanted with Treasuries since the end of the 2008–09 financial crisis because of persistently low yields.
Bonnie Baha, co-director of credit research for the DoubleLine mutual funds, says she anticipated S&P’s move weeks before it happened. But that doesn’t mean she thinks Treasury yields will rise high enough (or even at all) to make government bonds competitive income investments, especially with the threat of a new recession looming. Baha thinks current, though depressed, T-bond yields already reflect Uncle Sam’s diminished credit standing (as of August 8, ten-year Treasuries yielded 2.3%).
My advice: If you own Treasuries or built a ladder of government bonds in previous years, don’t sell them. But do not buy new Treasury bonds as your older ones mature. That’s not because of S&P’s rating downgrade; it’s because you can get a better deal elsewhere.
Treasuries are still suitable as part of an emergency reserve that places a higher value on safety than yield, says Connie Stone, of Stepping Stone Financial, in Chagrin Falls, Ohio. But for serious income, advisers nowadays suggest you look to corporate or municipal debt, depending on your tax situation.
In both categories, it’s best to concentrate on investment-grade bonds, which means those rated BBB or better. Junk bonds got hammered, unlike investment-grade bonds, on August 8, the first trading day after S&P announced its downgrade, and junk will continue to perform poorly if the economy falls back into recession.
For those investing in tax-deferred accounts, Stone recommends funds that invest mainly in high-grade bonds. These could include Dodge & Cox Income (DODIX) and Harbor Bond (HABDX), both members of the Kiplinger 25. The former invests mainly in corporate bonds and yields 3.5%. The latter is a clone of Pimco Total Return, the world’s largest bond fund; it yields 2.2%. For high-bracket folks investing in taxable accounts, she suggests municipal bonds backed by essential-service revenues, such as those from water and sewer services. You can find munis maturing in ten years that are rated AA+ and paying 2.8% to 3.3%. A 3% tax-free yield is the equivalent of a taxable 4.6% for an investor in the 35% federal tax bracket. Fund investors should consider Fidelity Intermediate Municipal Income (FLTMX), also a member of the Kiplinger 25. It yields 2.4%.