Some fixed-income managers predict a shortage of U.S. Treasury bonds, and are buying them now in anticipation of reaping profits later.
Other managers dismiss such predictions as nonsense.
Those warning of a potential shortage say supply already is starting to shrink, due largely to a reduction in the federal deficit and a the likelihood of a balanced budget. Demand, meanwhile, is escalating.
Those who pooh-pooh that theory point out the government always will have a need to sell debt to fund such ongoing expenditures as Medicare and Medicaid. Many in this camp are trimming their allocations to Treasuries, opting instead for the higher returns available from corporate bonds and mortgage-backed securities.
But Brent Harris, managing director at Newport, Calif.-based Pacific Investment Management Co., where around $35 billion of its $88 billion fixed-income portfolio is invested in Treasuries, said the firm's strategists expect the supply of new Treasuries will be sharply cut by October when the new fiscal year starts.
"The government has cut back on spending and tax revenues have been flowing in, thanks to profits from the stock market. The deficit is expected to be under $50 billion by next year," Mr. Harris said.
This is all positive for Treasury bonds, which are yielding around 65 basis points more now than they were at their peak in 1993. It adds to their value, Mr. Harris said.
To deal with potential supply problems, PIMCO is taking more rate risk at a time when bond investors might take less, Mr. Harris added. "Most are buying an intermediate term of 4.7 years, while we're buying a little longer duration than that, which means our returns will be better if bonds continue to go up."
Longer term bonds tend to rally more when interest rates fall, which makes them worth more than those with a shorter duration.
Another cornerstone of PIMCO's investment strategy has been to reduce corporate bond holdings to 10% of the portfolio, because the spread on corporates is "minuscule," according to Mr. Harris. The remainder is split between 40% in Treasuries, 40% in mortgage-backed securities, 5% foreign hedged bonds and 5% cash.
Gilbert Garcia, director of domestic investments at Smith Graham & Co., Houston, also foresees a potential shortage of Treasuries. "We expect to see less borrowing down the road. In addition, the Treasury is issuing inflation-linked bonds, which attracts a different buyer and will cut further into the supply of government issues."
Given current market concerns about inflation and low unemployment, Mr. Garcia said he normally would be taking a short position. But because of potential supply problems and excess liquidity, the firm is continuing to buy Treasuries. In addition, Smith Graham is moving into alternative investments such as private debt placements, he said.
Last week for example, Hutchison Whampoa Finance Ltd. of Hong Kong sold $2 billion of debt in a private placement, up from what was supposed to have been a $1.2 billion dollar deal. "It was oversubscribed and gobbled up," said Mr. Garcia, who oversees $2.3 billion in assets at Smith Graham, with the lion's share being $2 billion in domestic fixed-income. He said he put in orders for $50 million of the Hutchison deal, but was only able to get $15 million.
As the spreads have narrowed, his clients have been considering a range of other opportunities, from international bonds for domestic mandates to commercial real estate to private placements.
However, other managers emphasized a Treasury supply problem is more of a longer term issue, saying they have sufficient Treasuries for current needs and don't see any immediate problem.
"Maybe there will be temporary shortages, but we're not going to be running a consistently balanced budget, so the government will continue to sell debt," argued Charles Smith, managing director at T. Rowe Price Associates, Baltimore. He oversees $3 billion in fixed-income assets.
In fact, in the last six months he has been swapping Treasuries for corporate bonds and mortgage-backed securities of the same duration and now allocates only 17% of his portfolios to Treasuries, with 45% in mortgage-backed securities and 38% in corporates. "If we were to see a slowdown in the economy or a recession, then I would buy Treasuries again. But the way the economy is going now, I wouldn't have any reservation about continuing our current strategy," Mr. Smith said.
Back Bay Advisors L.P., Boston, which has $7.2 billion in bonds under management, also has been downplaying Treasuries, said Chief Investment Officer Ted Reed. "If we were to see rates rise, we'd switch into Treasuries, but we've been comfortable underweighting with 10% at this point." His benchmark, the Lehman Brothers Aggregate Bond Index, holds 44.7% in U.S. Treasuries.
Even though the economy has continued to expand in the past five years, Mr. Reed doesn't foresee any recession in the near term, which in turn means the spreads between Treasuries and other bond classes are unlikely to widen. He sees no reason to buy more Treasuries for the next two to three quarters. Instead, he prefers to stick with 50% corporate bonds and 25% mortgage pass-throughs.
He acknowledged that a minority of money managers - those who have a mandate to own Treasuries - could run into difficulty if a shortage should materialize, but noted there aren't a lot who would be affected. "Most would have the option to buy other government issues such as Fannie Maes and Ginnie Maes. Many of us also like Yankee bonds and high-yield bonds."
If there is a shortage, however, the government will be the biggest beneficiary, Mr. Reed added, because it will be able to roll over debt at lower interest rates.