Despite Low Rates, Investors Rely On Treasuries

Here’s another sign of just how weak the US economy is: The interest rate on the 10-year Treasury bond issued by the government fell last week to 1.5 percent. That means, if you bought such a bond and inflation stayed about where it is now, you wouldn’t make any money.

“You would get principle back,” says John Canavan, who covers the credit markets at Stone and McCarthy. “In real terms, if inflation over the next 10 years is more than 1.5 percent, then yes, you would end up with a little less money than if you simple hoarded cash.”

In other words, investors are paying the U.S. government to hold onto their money. They’d be better off keeping their money under a mattress. And yet, people all over the world keep buying U.S. Treasury debt.

The rates on Japanese and German debt are even lower. Why would anyone buy a bond with such a poor return?

For one thing, Canavan says a lot of fund managers all over the world have money to invest right now, and they’re required to do something with it. They can’t just hold it as cash.

“They have to find a place to invest,” Canavan says. “So for Treasuries, they’re willing to accept the risk of walking away with somewhat lower real returns in return for just getting it all back.”

In this highly volatile world economy — with much of Europe in a recession and China slowing — investors just don’t know where to put their money. And so they’d rather sink it in U.S. government debt. They might lose a little money there but at least the losses won’t be too great.

Joseph Gagnon, senior fellow at the Peterson Institute for International Economics, is a little perplexed by how risk-averse investors have become. He says there are a lot of good investment opportunities right now — like corporate bonds and stocks that pay dividends – and yet investors don’t bite.

“American corporations are sitting on record pile of cash just sitting in bank deposits and Treasury bills and bonds at these low rates when they could be investing in something that could make a profit and that is what I don’t understand,” Gagnon says.

He says a lot of this is because of a weakness in demand. It’s the same reason companies don’t want to build new factories or hire people. They’re worried that they won’t be able to sell what they make.

Gagnon says in an environment like this, something unusual happens to the markets.

“One of the things that really marks this crisis, and marks crises in general, is that interest rates on the safest assets decline more than other interest rates.”

He says investors always want a little more money the riskier an asset is. They demand a higher rate for a junk bond than a municipal bond for instance. The difference between the two is called the spread. In fearful times like this, the spread tends to widen.

Take mortgage rates: They’ve fallen a lot in recent years and it’s benefited the housing market. But they haven’t fallen as far as Treasury bonds. Banks would rather keep their money in safe assets like Treasuries than lend it out for mortgages that could go bad.

Gagnon, who used to work at the Federal Reserve, says the Fed can do things to bring mortgage rates down even further.

“If they do more action, that’s where I would focus it on, because that spreads widened lately and it could come down,” he says.

The Fed has already been doing this — buying up long-term debt and making more money available to the mortgage market. But as investor confidence wanes, the Fed may decide it’s time to step up its efforts.

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