BL/Five-Year Claims Yield Sweet Spot With Inflation Up, Rates Down
By Sandra Hernandez
April 21 (Bloomberg) -- Bond investors anticipating faster inflation and the end of interest-rate cuts by the Federal Reserve are finding refuge in five-year Treasuries.
The highest yields relative to two-year notes since 2004 make five-year securities attractive at a time when the central bank is running out of room to lower borrowing costs. Plus, they are less sensitive to changes in inflation expectations than longer-maturity debt, a benefit with oil above $110 a barrel and corn close to a record high.
``The five-year is really kind of the sweet spot,'' said Jason Brady, a managing director in Santa Fe, New Mexico, at Thornburg Investment Management, which oversees $4 billion in fixed income. Two-year notes will lag behind longer maturities as ``Fed aggressiveness gets taken out,'' he said. Ten- and 30- year Treasuries ``look awful generally,'' Brady added.
Investors are gravitating toward five-year notes on speculation policy makers won't cut their target rate for lending between banks below 1.75 percent from 2.25 percent now. Two-year notes have yielded an average of 41 basis points, or 0.41 percentage point, more than the Fed's rate the past 20 years. They traded at a yield of 2.13 percent last week.
At the same time, five-year notes offer more protection than longer-maturity debt against inflation, which erodes the purchasing power of interest payments over time. Faster inflation tends to widen the difference in yields between short- and longer-maturity debt. The spread for the so-called yield curve is currently about 1.56 percentage points, compared with an average of 0.36 percentage point during August, when the rate of inflation was less than half the current 4 percent annual pace.
`Favor Fives'
``We favor fives versus both ends of the yield curve,'' said Naruki Nakamura, a portfolio manager in Tokyo for Fischer Francis Trees & Watts Inc., which oversees more than $30 billion of bonds worldwide and is part of BNP Paribas SA, France's biggest bank. The Fed will cut its rate to 1.75 percent and leave it unchanged for at least a year, he predicts.
Fischer Francis holds a greater percentage of five-year notes than contained in the benchmark it uses to measure performance, Nakamura said.
The yield on the benchmark 2 1/2 percent note due in March 2013 rose 32 basis points last week to 2.89 percent as its price fell 1 14/32, or $14.38 per $1,000 face amount, to 98 7/32, according to BGCantor Market Data. Two-year note yields climbed even more, increasing 39 basis points to 2.13 percent.
The 76-basis-point difference is down from 97 basis points March 6, which was the largest spread since August 2004. As recently as 2003 the gap was 161 basis points. In 2006, five- year yields fell 19 basis points below two-year yields.
Fed Minutes
The narrowing of the spread in recent weeks shows that five-year Treasuries have held up better than two-year notes in the sell-off the past month. Bond investors can profit by betting on the relative value of yields between different maturities even when the market is falling.
Minutes of the Fed's March 18 policy meeting signaled officials will slow the pace of interest-rate cuts. ``Members recognized that monetary policy alone could not address fully the underlying problems in the housing and financial markets,'' according to the minutes, which were released April 8.
The last time five-year Treasuries outpaced two-year notes on speculation the Fed would stop cutting rates was the second quarter of 2003. Five-year debt returned 2.5 percent between April and June, compared with a gain of 0.9 percent by two-year notes. The Fed cut its benchmark rate in June, the last change before it began raising borrowing costs a year later.
Rate Outlook
Traders see no chance the Fed will lower rates by a half- percentage point to 1.75 percent at its next scheduled meeting on April 30, down from 88 percent odds a month ago, according to futures contracts on the Chicago Board of Trade. The majority of the bets are for a quarter-point reduction.
The central bank will start raising the rate from 1.75 percent in the first three months of 2009, according to the median estimate of 57 economists surveyed by Bloomberg News between April 2 and April 8.
``The five-year seems a decent place to be able to capture some of the flight-to-quality potential,'' said Mitchell Stapley, who oversees $22 billion as chief fixed-income officer for Fifth Third Asset Management in Grand Rapids, Michigan. ``We've got some risks in the long end of the curve and two- years just look horrifically rich.''
Consumer prices in the U.S. rose 4 percent in March from a year ago, more than double their pace in August and close to a two-year high of 4.4 percent in November. The price of crude oil has risen 86 percent over the past 12 months.
More to Lose
Should investors become less concerned about inflation or more optimistic the economy will rebound, five-year notes have more to lose than longer maturities, said Robert Tipp, chief investment strategist for fixed income at Prudential Investment Management, which oversees about $200 billion of bonds.
``Market psychology can change quickly,'' said Tipp, who is based in Newark, New Jersey.
Economic growth slowed in nine of 12 U.S. districts since February, hurt by ``anemic'' real estate markets and a slowdown in consumer spending, the Fed said April 16. Even so, Federal Reserve Bank of Dallas President Richard Fisher said the next day that he's hesitant to lower rates further, warning against ``inflating'' the economy out of the credit crisis.
As investors realize the economy isn't going to rebound quickly and the yield curve flattens, they're likely to be thinking ``aren't you happy you were in the five-year and not the two?'' said James Cusser, who manages $1.5 billion at Waddell & Reed Inc in Overland Park, Kansas. Five-year notes remain the ``safest'' Treasury security, he said.
To contact the reporter on this story: Sandra Hernandez in New York at shernandez4@bloomberg.net
Last Updated: April 20, 2008 11:00 EDT
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