Bear Giveth as Well as Taketh Away (Treasury Edition)

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While we’re have a cliche fest, an ill wind blows nobody good, and it looks like that Bear Stearns hedge fund debacle had some unexpected upside, namely, producing a flight to quality, meaning Treasuries, sparking a rally.

I’m sure you could have said the same of past crises (just for starters, the 1997 emerging markets crisis, the LTCM meltdown, 9/11) but no one would have put quite such a chipper spin on it.

The reason this story isn’t quite as loopy as it might seem is that a few weeks ago, there was what amounted to a market break in Treasuries, a move significant enough not only to rattle investors but also to represent a change in well established trading patterns. Traders saw it as a watershed, a definitive sign of the end of the cheap credit era.

This latest development doesn’t necessarily disprove that thesis; the Treasury bond move is accompanied by widening spreads for riskier credits. Risk premia rise in a weakening credit environment. So it is still possible that we’ll see a resumption of interest rate increases after investors have gotten further with swapping out of riskier assets into Treasuries.

From Bloomberg’s “Bear Stearns Dismembers U.S. Treasury Bear Market “:

Treasury investors can thank Bear Stearns Cos. for smothering the bear market.

Traders who cut their holdings of U.S. government debt just a few weeks ago as retail sales increased and job growth accelerated are now snapping up Treasuries. Demand is being fueled by speculation that losses at hedge funds owning subprime mortgage bonds such as those managed by New York-based Bear Stearns and London-based Cambridge Place Investment Management LLP will spread and slow the economy.

Treasuries made up 35 percent of funds overseeing $315 billion of bonds, compared with 34 percent for riskier assets such as corporate debt and emerging market securities, according to a June 29 survey by Ried, Thunberg & Co., a Jersey City, New Jersey-based research firm. Treasury holdings exceeded corporate and sovereign debt for a second consecutive week.

“It’s a story of yields and risk premiums working their way back to fair value,” said Colin Lundgren, who manages $40 billion for RiverSource Institutional Advisors in Minneapolis. “The story has shifted from economic data to the subprime mess and how investors are positioned.”

Lundgren said he used cash to raise holdings of Treasuries 6 percent in June. The yield on the benchmark 4.5 percent note due in May 2017 rose to a five-year high of 5.327 percent on June 13.

The 10-year note’s yield fell to 5.03 percent on June 29 from 5.13 percent a week earlier, according to New York-based bond broker Cantor Fitzgerald LP. The yield was little changed today. The securities returned 1.9 percent since June 13.

Hedge Fund Wreckage

Investors typically prefer Treasuries in times of turmoil. U.S. debt outperformed corporate and emerging-market bonds last month for the first time in a year. Treasuries fell 0.2 percent, compared with 0.8 percent for corporate securities and 1.8 percent in debt of less-developed countries, indexes compiled by New York-based Merrill Lynch & Co. and JPMorgan Chase & Co. show.

Yields on 10-year notes fell to 4.16 percent during October 1998 from about 5.5 percent two months earlier following Russia’s $40 billion default and the collapse of Long-Term Capital Management LP, the Greenwich, Connecticut-based hedge fund that required a $3.6 billion bailout from Wall Street banks.

The unraveling of hedge funds run by Greenwich-based Amaranth Advisors LLC in September contributed to a quarter- percentage-point drop in 10-year yields to 4.54 percent.

This time, investors are buying Treasuries as the highest mortgage defaults in a decade cause losses at hedge funds that loaded up on securities backed by loans to homebuyers with poor or limited credit. They’re concerned that riskier assets may be the next to decline after the U.S. economy grew at the slowest annual pace in four years during the first quarter.

Bear Stearns Trigger

Bear Stearns offered $3.2 billion of credit lines to rescue one of its hedge funds last month. The amount was reduced to $1.6 billion after the firm sold some securities and lenders took others as collateral. Cambridge Place said last week that it will close Caliber Global Investment Ltd., a fund that had $908 million of assets in March.

Bear Stearns is “very definitely” the trigger for the current rally, said Daniel Fuss, a vice chairman at Boston-based Loomis Sayles & Co. whose Loomis Sayles Bond Fund has been the best performer among its peers the last decade. The fund bought more Treasuries and cut back high-yield holdings, said Fuss, who predicts the yield on 10-year notes will fall to 4.5 percent this year.

“I’m personally very cautious about the risky side of the fixed-income market,” said Fuss. While the losses from Long-Term Capital were contained by the securities firms and banks that traded and loaned money to the hedge fund, “this one has certainly fed into the broader economy via the mortgage market,” he said.

Treasury Bear Market

The housing slowdown shaved about 1.5 percentage points from gross domestic product in the first three months of 2007, said William O’Donnell, U.S. government bond strategist at UBS Securities in Stamford, Connecticut.

Government bonds were in a bear market this quarter before the hedge funds collapsed as the combination of a rebound in economic growth and speculation that inflation would accelerate all but eliminated expectations that the Federal Reserve would cut interest rates.

Treasuries lost 0.4 percent in the quarter, the biggest decline since the first three months of 2006, according to Merrill Lynch indexes.

Fed funds futures prices suggest a 30 percent likelihood the central bank will lower its 5.25 percent target rate for overnight loans between banks to 5 percent by year-end, compared with 3 percent on June 18.

Spreads Widen

Fed policy makers last week gave no indication they plan to reduce the target for overnight loans between banks. “Readings on core inflation have improved modestly in recent months,” the Fed said in its June 28 statement after leaving rates unchanged. “However, a sustained moderation in inflation pressures has yet to be convincingly demonstrated.”

The Commerce Department said June 29 that its price index for personal consumption expenditures excluding food and energy, the Fed’s preferred inflation gauge, increased 1.9 percent in May from a year earlier, the smallest rise since May 2004.

Treasuries of all maturities have gained an average of 1 percent this year compared with a 1.2 percent first-half loss last year, Merrill index data show.

Investors demanded an extra 1.46 percentage points in yield to own corporate bonds rather than Treasuries at the end of June, up from 1.33 percentage points on May 31. The spread for emerging-market bonds widened 0.27 percentage point to 1.76 percentage points, according to JPMorgan’s Emerging Markets Plus index.

Investor Sentiment

“I don’t think it’s a bold forecast to say I would expect it to continue to widen,” said George Fischer, who manages about $17 billion in fixed-income assets at Boston-based Fidelity Investments, the world’s largest mutual fund company.

JPMorgan says investors in Treasuries are the most bullish in more than five years. A weekly index by the third-largest U.S. bank, which subtracts the percentage of investors expecting bonds to fall from those forecasting a rise, reached 31 for the period ended June 25, the highest since a reading of 36 on Jan. 7, 2002.

Ried Thunberg’s June 25 survey found that 84 percent of its respondents don’t see the housing market bottoming until the fourth quarter at the earliest. Investors increased their holdings of Treasuries from 29 percent in the June 8 survey.

Robert Calhoun added Treasuries with longer maturities, which gain more when yields decline, to the $50 billion he oversees as chief investment officer at Tattersall Advisory Group, a Richmond, Virginia-based unit of Evergreen Investments.

“I’m surprised” Treasury yields “are as high as they are given the risks,” he said.

Best Value

A jump in mortgage rates this month and a glut of unsold properties will discourage construction, economists said. The housing slump, the worst since 1991, will restrain the economy for the rest of the year and potentially into 2008, said Bill Gross of Pacific Investment Management Co.

The best value is high-quality, shorter-maturity debt because weakness in housing and consumption will force the Fed to lower its target rate, said Gross, who runs the $103 billion Total Return Bond Fund for Pimco in Newport Beach, California. Pimco is a unit of Munich-based Allianz SE.

“We think this particular problem in terms of subprime credit extends into other credit areas,” Gross said during a June 26 interview from his office. “We want to stick to high quality and ultimately the front end of the yield curve as ultimately the Fed has to lower interest rates in order to bolster consumption and bolster housing.”

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