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Economic and Market Commentary

Imagine...(The End of Treasuries and The Last Bond)

For those of you who want to know what the Fed is going to do over the next few months, I’ll be brief: Greenspan will raise rates until he sees the whites of a slowdown’s eyes. But this Outlook is not about the Fed or Alan Greenspan. He’s a smart guy and they’re a bunch of smart men, but the Fed’s following the New Economy just like the rest of us – with hesitation, and uncertain answers to questions that need lots of lifelines. Regis should be on the Fed if Clinton had any sense. Since he’s not, we’ll all just have to wait and see how quickly a New Age economy and a New Age stock market react to 6½% or higher Fed Funds. I’ve got a hunch it’s sooner than most people think, but that’s definitely not my final answer.

No, this Outlook is about “The End of Treasuries and the Last Bond.” Not that I believe that – anymore than Francis Fukayama believed in the end of history – but it makes for a good title and the concept itself is worth exploring. Sometimes it helps me to do thought experiments – wondering in this case what would happen if the U.S. Treasury surplus was so large and lasted for so long, that at some point in 2015 or so there would only be one Treasury bond left – probably held by some little old Japanese lady – because the Japanese like to invest in bonds with as low an interest rate as possible.

But travel with me in space and time and try to imagine that last Treasury bond. I know it takes some imagination because the New Age economy and its expected surpluses are by no means a slam-dunk, whereas the ability of our politicians to spend money is . Shaquille O’Neal, the master slammer jammer, is a 5-foot choirboy compared to even the most conservative Representative on the Hill. But just “imagine,” as John Lennon used to sing. Imagine if the U.S. Treasury keeps on retiring and buying back all of its debt, at what yield and at what price would that last Treasury bond be “trading” in 2015? Gosh, I can imagine almost any number I suppose, between 1% and maybe 5% with a best guess somewhere around 4%. If you said something different I couldn’t argue strongly against you, but let’s just say 4% for the moment and see where it takes us. At a 4% yield with a remaining 15-year maturity or so, that last Treasury bond would be “trading” at a price of 125 or so given current present day coupons of 6¼%. Maybe not such a bad investment after all for that little old Japanese lady. 6¼% interest per year plus 25 points capital appreciation would give her a more than 7½% annualized “total return” over the decade and a half. And I said Japanese investors were naive! Sure that’s the return for just the last bond, but the fact is that each and every long Treasury sold back to the government over that 15-year period of time would provide a return of close to 7½% assuming a straight line, linear path from today’s levels to our 4% benchmark in 2015.

Imagine There’s No Treasuries, It’s a Little Hard…But Try
Figure 1 is a line graph showing a hypothetical scenario of how bond yields could tend to fall if the U.S. Treasury were to keep retiring and buying back all of its debt. The hypothetical time period, on the X-axis, runs from 2000 (when the figure was published) to 2015. Coupon is shown inversely on the Y-axis, from 6% at the bottom, and 4% at the top. In Year 2000, the coupon is in the bottom left-corner of the graph, at a coupon of 6%. It rises to 4% by 2015. The chart indicates a total return of 7.5% over that time frame.
Figure 1
Source: PIMCO

For example, by choosing to sell your Treasury bond back to the government before that little old lady (call it the penultimate bond just to simplify things) at say 5% in the year 2010, you’re still going to capture close to a 7½% total return, although admittedly for a shorter time period.

Now I hope I haven’t lost all of you non-bond, non-mathematical types by now. This stuff can get a little tricky or boring, or both. But my John Lennon type experiment is really quite crucial to put the impact of the government surplus and its buyback program in proper perspective. It tells a bond investor that if the last Treasury bond trades at a 4% yield in 2015 and it moves there linearly, then long Treasuries will provide a 7½% annual total return. Like I said, that’s pretty good, but there are a few big ifs there that even the Shaq would dispute. What if the last Treasury bond trades at 5, 6 or heaven forbid 7%, instead of 4? What if the Treasury surplus returns to deficit, given politicians’ propensity to spend, or we simply have a good old fashion economic recession? Well, in those cases, our Japanese lady is not going to get her 7½%, but instead will be earning a 6¼% coupon and just a little bit extra if she’s lucky, or a little bit worse if the yield curve returns to where it was in late 1999 before all this hullabaloo broke out.

But what if instead of my “Imaginary” example of that last Treasury bond and all of its predecessors, I showed you an investment that wouldn’t need any lifelines or half guesses to get you to 7 ½% and beyond? What if I showed you a government-guaranteed security just like those Treasury bonds but with a “total return” likely to be higher than the 7½% provided by long Treasuries without all the question marks? What if I showed you the slam dunk, Shaquille O’Neal, MVP or in this case MVI (Most Valuable Investment), for at least the next several years? I shall, because as clients, that’s what you pay me to do, and if you’re not a client, well maybe you should be because PIMCO’s been buying these things for several months now and our numbers compared to our competitors are looking very good, thank you very much. My final, final answer Regis is……a GNMA – Government National Mortgage Association passthrough. These securities of course, have been around since the early 1970s and are pools of individual FHA/VA mortgages guaranteed by the U.S. Treasury. While subject to prepayment “risk” which can change their average lives, they nevertheless possess a valuable characteristic that pure U.S. Treasuries do not have: they yield 8¼%. As we’ve seen in our “last bond” analysis, the highest reasonable expectation for long Treasuries (or any Treasury for that matter) would be 7½%. We therefore have a “slam dunk,” government guaranteed investment that yields at least 75 basis points more than the best case Treasury. Actually, to my mind, its “total return” (yield + price change) could be even higher in an unchanged interest rate environment, because its increasing value (and PIMCO sponsorship) should result in price appreciation as well. GNMAs to my best guess are an 8½% “total return” investment over the next 5-10-15 years. Even if U.S. Treasuries disappear, the holder of a GNMA should do better. If there should be no “last bond,” they’ll do much better.

Some of you may find this conclusion a little bit confusing in light of PIMCO’s innovative advocacy of Treasury notes and bonds since early February. I did, in addition, announce on Wall $treet Week with Louis Rukeyser that I was a Bruce Springsteen bond investor – purchasing issues that were born in and guaranteed by the USA. That remains true but as this analysis points out, there are several ways to approach the Springsteen/Lennon paradigm. GNMAs, over time, should be the most profitable one, although short-term “basis” changes may throw a little egg on the Boss’ face.

GNMAs and Treasuries, of course, are not the only bonds in the world. There are Agencies and corporates – both investment grade and high yield, – etc., etc. As I strongly stated in my April Investment Outlook, however, our New Age economy is an economy that favors government securities – not just because of supply and demand considerations – but because of its deleterious effect on corporate bond quality . Upgrade, upgrade, upgrade has been the PIMCO credo in the year 2000. GNMAs, GNMAs, GNMAs have been the reciprocal investment.

Francis Fukayama wasn’t wrong in my opinion, just a little shortsighted. There is no end of history - only an endless succession of new beginnings. Likewise with bonds, there may be no “last Treasury,” only an endless stream of government bonds to satisfy politicians’ needs for career enhancement. But even if they do disappear, King Treasury has already abdicated his crown. Long live the Queen – Ginnie Mae. You’ll not find a better investment in the bond market today.

So, with apologies to John Lennon:

Imagine there’s no Treasuries,
It’s a little hard…but try
No borrowing or deficits
No bonds or notes to buy
Imagine all the people
Buying GNMAs…


You may say I’m a dreamer
But I’m not the only one
I hope some day you’ll join me
And the world will be as one.

William H. Gross

Managing Director


No part of this publication may be reproduced in any form, or referred to in any other publication, without express written permission.
This article contains the current opinions of the author but not necessarily Pacific Investment Management Company, and does not represent a recommendation of any particular security, strategy or investment product. 
The author's opinions are subject to change without notice. Information contained herein has been obtained from sources believed to be reliable, but is not guaranteed.
This article is distributed for educational purposes and should not be considered as investment advice or an offer of any security for sale. Past performance is not indicative of future results and no representation is made that the stated results will be replicated. Copyright ©1999-2003 Pacific Investment Management Company LLC. All rights reserved.

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