Adviser Soapbox
Cash Is King When Treasuries Are Bubbly
Mark Sunshine 05.22.09, 11:25 AM ET

Many of my friends are nearing retirement age and, after getting buried in the stock market, they are afraid to invest in anything that has risk. They want to buy investments that have a reliable income and think that Treasury notes, bonds and funds that hold them are good alternatives.

With short-term interest rates near 0%, they think that cash is trash and want to go long in the Treasury market. I told them to stay in cash even though 10-year Treasury yields have risen by more than 1% since December. Returns on long maturity Treasuries are still too low to be interesting, and there is a good chance that my friends are going to sustain market-value losses when interest rates rise, which will sooner or later happen during the life of 10-year notes.

I also caution them not to buy Treasury bond mutual funds, government mortgage funds or anything else that is tied to the 10-year Treasury. There are a whole bunch of problems with 10-year Treasuries, and cash is a pretty good investment alternative right now. The chief problem is that the Federal Reserve is keeping yields artificially low by purchasing Treasury notes and bonds as part of their quantitative easing program. This program has several objectives and one of them is to push Treasury yields lower than justified by market fundamentals.

Since March 25, the Federal Reserve has purchased more than $115.5 billion of Treasury bonds and notes, and it has been pretty successful in its mission to push long maturity Treasury yields lower. In fact, the Federal Reserve has been so successful at forcing down interest rates that with 10-year Treasury yields hovering just above 3%, there are no natural long term domestic institutional buyers such as banks, insurance companies and pension funds.

I have a strict rule of investing, which is that individuals shouldn't buy investments that institutions cannot or will not purchase. When individuals disregard this rule, they turn into the investor of last resort and almost always lose money. I am certain that if my friends directly or indirectly purchase long maturity Treasuries at today's interest rates they will be sorry. Domestic institutions can't buy long- term Treasuries because, unlike the Federal Reserve, private institutions cannot just "print money" to buy Treasuries.

In order to invest, they have to borrow money and the cost of borrowing is greater than the yield on long maturity Treasuries. Even for banks that can borrow money by taking in checking deposits that pay no interest, it doesn't make sense to purchase long-term Treasuries. As it turns out, typically checking accounts cost banks as much as 3% in operating expenses, which is approximately the current interest rate on 10-year Treasury notes.

Banks start to become natural buyers of Treasuries when 10-year yields are above 5%. The more that yields rise above 5.00%, the greater the appetite of banks for 10-year government paper. During the bank and thrift crisis of the late 1980s and early 1990s, a great deal of buy-and-hold demand for Treasury securities came from domestic banks, which are the very same institutions sitting on the sidelines today.

Of course, from 1987 to 1993 the 10-year constant maturity Treasury yield was as high as approximately 9.35% and only went as low as approximately 5.25% by 1993. Banks were able to make money and avoid risk by purchasing long maturity Treasuries. That opportunity doesn't exist at today's yields. It isn't much different for insurance companies, pension funds and nonprofit entities. If these institutions lock in current 10-year Treasury rates, they will fail to earn enough to meet their obligations to policyholders, pensioners or beneficiaries.

After all, what insurance company or pension fund promises retirees a 1% to 2% annual investment return, which is the net yield after operating expenses for companies that invest in 10-year notes at today's yields? Even foreign investors are shying away from long-term Treasuries, requiring higher yields at recent auctions. Apparently foreign investors think that interest rates are going to rise and destroy the value of their investments.

As I tell my friends, don't buy long maturity Treasuries. Their present yield and recent appreciation are functions of Fed-induced bubble and will surely cause future pain for long-term savers. I tell my friends to keep their fixed income money in cash and short term investments--just like the Chinese government does. Cash is not trash if you are waiting for long term interest rates to rise.

Mark Sunshine is president of First Capital in Boca Raton, Fla., and author of the Mark Sunshine Economics Blog.