- Are US Treasuries the new CDO's?

Everyone knows that a castle built on sand is a poor risk. In the global investment marketplace, it has long been assumed that the U.S. Treasury bond is like a castle built on bedrock: perhaps not very exciting, but totally reliable. But how should investors respond to the notion that the bedrock foundation of the T-bill is more unstable than it may appear?

In recent years, Treasuries have exhibited significant daily volatility, caused in part by the unprecedented market conditions. Going forward, government bonds could continue to see fluctuations in value. Here are a few reasons why T-bills and bonds may exhibit uncomfortable volatility.

90-day realized volatility-over-time of the CBOT (CME) 10 Year bond future generated using the RiskAPI Add-In.

• Investors are closely watching the moves of the Federal Reserve, and every indication of a change in interest rate policy can send equity markets either soaring or sinking. Interest rates can't stay at near zero levels forever, and once the Fed resumes activity in this area, trading activity could surge.
   
• Inflation may place Treasuries into sharper focus. While most economists agree that the consumer price index (CPI) will rise from current levels, opinions as to just how high inflation will go vary significantly. Some see moderate rates, while others predict a steep rise that will hit double digits. Since Treasuries are fixed-income investments, the buying power of coupon payments is affected by the current rate of inflation. As the recovery progresses, Fed meetings and releases of CPI data will become important benchmarks for everyone on Wall Street.
   
• The operations of government-sponsored enterprises may drag down government bond value. For example, Fannie Mae and Freddie Mac are still deep underwater. When concerns arose in September 2008 regarding the ability of the twin GSEs to make good on their guarantees, the Federal government effectively nationalized them at the taxpayers' expense. The crisis has not passed. In the first quarter of this year Freddie Mac lost $6.7 billion, and its net worth plunged by $14.9 billion, putting it over $10 billion in the red. The mortgage giant is asking the Treasury Department for $10.6 billion in aid.
  

Fannie Mae and Freddie Mac mortgage-backed securities (MBS) have been propped up by the combination of $1.25 trillion in purchases by the Federal Reserve to support U.S. housing markets, and Treasury credit support in the form of guarantees if mortgages in individual MBS default. In March, the purchases ended.

Taxpayers have already shoveled $127 billion to these enterprises, and may have to provide hundreds of billions more. To ensure Fannie Mae and Freddie Mac can meet $4.6 trillion of guarantees on housing assets, the U.S. government has promised to pump unlimited cash into them through 2012. Taxpayers now own at least 80 percent of them, and guaranteed more than $1.7 trillion in Fannie and Freddie debt and $5 trillion in mortgages. While they remain a huge part of the U.S. investment-grade bond market, analysts see very little upside and more risk for new purchases today.

Realized volatility (Jan 2010-present) of major U.S. bond contracts generated using the RiskAPI Add-In.

The debt crisis overseas impacts the value of Treasuries. Speculation that Greece's debt crisis will drag down other European countries drove investors to the relative safety of Treasuries and made interest rates more volatile, damaging mortgage bonds. The news of a bailout for Greece eased upward price pressure on T-bills. But the problem is not solved yet; some analysts have suggested that it is not out of the realm of possibility that if several countries default, there's a chance Fannie Mae and Freddie Mac eventually could too.

For information on powerful risk-management tools that allow you to track and measure the risk of global financial futures, sovereign debt, and corporate bonds contact PortfolioScience today.

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