Worried about a Treasury bubble?

Raman Srivastava, Portfolio Manager, Absolute Return 100 Fund and Putnam Absolute Return 300 Fund, 9/21/10

In August, the 10-year Treasury yield reached 2.5%, its lowest level since December 2008, when the U.S. economy faced some of the most daunting conditions since the Great Depression. Yields have reached low levels in spite of a record government deficit, and in a period of growing concern about the risk of sovereign default that surfaced during the European debt crisis in the first half of 2010.

Past performance is not a guarantee of future results.
Source: U.S. Federal Reserve.

Some have argued that these low yields and high Treasury prices — bond prices move inversely to yields — signal that Treasuries are in the midst of an asset bubble. When bubbles come to an end, the aftermath can be a long period of underperformance. As an example, U.S. stocks generated little capital appreciation in the 10 years following the end of the great bull market in 2000, which many observers believed was a stock bubble. In the case of Treasuries today, a bursting bubble would mean plummeting bond prices and sharply rising yields.

Despite the debate about a possible bubble, it appears that many investors have grown increasingly comfortable with Treasury bond exposure, judging by the large amount of investment that has flowed into Treasuries this year. However, even if worries of a bubble are overblown, we are concerned that it is unrealistic for investors to count on Treasuries continuing to deliver the same types of returns that they have recently provided. Treasuries have posted total returns of 6%–7% over the past year, and matching that return in the future, with current yields at 2.5%–3%, seems challenging at best, and the potential for Treasuries to deliver negative returns over the next year has grown more likely