Why Short-Term Treasury Issues May Be Good Bet

If you subscribe to the idea that bankers usually make the wrong moves with their money at the wrong time, one-to five-year U.S. Treasury securities could be the smartest investments to buy over the next few months.

Banks have poured cash into those short- and intermediate-term Treasuries over the last two years, as loan demand has sunk with the slow economy. With little else to do with their customers’ deposits, the banks have viewed Uncle Sam’s IOUs as a risk-free haven.

Now, expectations are growing that the economy will revive in 1993, and with it demand for loans by businesses and individuals. So some banks are beginning to raise cash for loans by selling their Treasuries. And that could present lucrative opportunities for other investors.

John Lonski, economist at Moody’s Investors Service in New York, notes that banks’ portfolio of short- and intermediate-term Treasuries rocketed from $563 billion at the start of the year to $635 billion on Sept. 30. Astounding as it may seem, those Treasury holdings now exceed the total $597 billion in loans that banks have outstanding to all commercial and industrial borrowers.

Indeed, more significant than the actual selling of Treasuries lately is simply bond traders’ fear of banks’ massive portfolio, and the perception that banks are certain to dump a large part of their holdings in the first half of ’93 to accommodate loan growth. If that should happen, interest rates could soar as investors demand higher yields to absorb the wave of bonds tossed on the market.

Unwilling to wait for the actual event, traders have pushed interest rates on shorter-term Treasuries up sharply in recent weeks:

* The discount rate on one-year T-bills has jumped to 3.53% from 2.84% on Oct. 1.

* On five-year Treasuries, the yield has surged to 6.04% from 5.26% in the same period.

Meanwhile, yields on longer-term bonds--which banks rarely own--have inched up only slightly. The yield on 30-year T-bonds now is 7.53% versus 7.32% on Oct. 1.

In bond market parlance, what’s happening is that the “yield curve” is flattening. In plain English, that means that the difference between short-term and long-term rates is narrowing.

Early last January, the discount rate on six-month T-bills was 3.91%, while the yield on 30-year T-bonds was 7.47%. So the interest premium you earned by “going long” was 3.56 percentage points a year.

By July that premium had ballooned to 3.97 points, and by early October it had reached a Grand Canyon-like span of 4.54 points. That wide spread occurred because most investors wanted to remain in “safe” short-term securities. To attract even a relative few buyers into longer-term securities, the premium had to be gigantic.

Wall Street knew that such a huge spread between short and long rates was unsustainable. What many investors counted on, however, was that long-term rates would fall to narrow the gap, rather than that short-term rates would rise.

In retrospect, the banks may have provided the clearest signal that things weren’t likely to play out as expected: Just as bankers’ rush to make commercial real estate loans in the late 1980s signaled that a real estate crash was inevitable, some bond experts warned in late summer that the bankers’ insatiable hunger for short- and intermediate-term Treasuries was a sign that that part of the market was ripe for trouble.

But some experts argue that the turmoil has already run its course. “This backup in rates has gone too far,” says William Griggs at investment firm Griggs & Santow in New York. The economy is unlikely to grow anywhere near as fast in 1993 as investors seem to believe, given the yields they’re currently demanding on shorter-term bonds, he says.

When expectations settle back down, Griggs says, so will shorter-term interest rates. The smartest move for individual investors, he says, would be to buy the very securities that some banks now are tossing out of their portfolios--especially Treasuries maturing in three to five years. At a 6.04% annualized yield, the five-year Treasury note offers a great return at relatively low risk, Griggs says.

Other bond players agree that yields on those securities are far more attractive now than two months ago.

But they also caution that fear of bankers’ herd mentality could drive yields even higher over the next few months, before the reality of the economy takes control again.

“There are so many owners of those shorter-term securities that they can push (rates up) a lot more if they so desire,” says Elliott Solomon, trader at CRT Government Securities in New York.

So if you’re eager to buy shorter-term Treasuries, the best advice may be to do it slowly over a period of months rather than all at once now.

Interest Rates: The Spread Narrows

For most of this year, the spread between short-and long-term interest rates was widening, encouraging investors to won longer-term securities. Now, as short-term rates rise, the spread is again narrowing.

Yield advantage, 30-year T-bond over six-month T-bill (in percentage points). January 3: 3.56 April 3: 3.68 July 3: 3.97 October 3: 4.54 November 17: 4.16