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THE BROYHILL LETTER

An investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return. Operations not meeting these requirements are speculative. Benjamin Graham, The Intelligent Investor

Executive Summary
Conventional investment wisdom disillusioned academics and institutional portfolio managers alike in 2008. Diversication strategies were a complete failure because this time around, there was no place to hide. Diversifying overseas disappointed investors looking for shelter. Value stocks offered no safe haven. Even economic sectors with traditionally defensive characteristics did not advance. Diversication into xed income was also a loser as investment grade corporate bonds tanked and municipal bonds suffered from a litany of concerns. Commodities proved to be among the biggest losers of all. The lonely winner for 2008 U.S. Government Bonds. Interest rates declined as ination became a no show. The return of principal became more important than the return on principal. Long dated bonds rose over 30% and the Dollar advanced as investor apprehension traveled around the globe. Treasuries have become the ultimate mattress into which nervous investors have stuffed money, pushing yields to record lows. As yields fall, prices rise and the yield on 10-year Treasuries recently dropped to 2.05%, the lowest level in more than 50 years. Meanwhile, the three month Treasury yield fell below 0%, a negative interest rate!! Imagine, effectively paying the government to hold your money. Thats an expensive mattress. If weve learned nothing else from recent history, we should at least recognize that bubbles always burst. This one will end badly, too.

Deation, Depression, and Despair

Fears about slowing economic growth, deation and collapsing nancial markets have produced record low interest rates and panic in the market for short dated paper. Safety at any cost has led to the anomaly of negative interest rates where investors will literally pay for the privilege of storing their assets in safety. As long as that focus remains, the demand for treasuries should remain strong, and their yields miniscule. Of course, if the economy stabilizes, the Fed may turn around and sell treasuries back into the market to sop up excess liquidity, pushing rates back up . . . and prices back down. Theres nothing wrong with holding short dated treasuries for short term needs. Sure, the yields may be nonexistent but thats the cost of avoiding any risk. The problem arises when investors remain enchanted with the security of the government guarantee but feel that they must reach for yield and lengthen maturities. While the yield on the 30-year Treasury is nearly 3% more than 3-month yields, if interest rates retrace this years course, investors could be saddled with 30% losses. Risking 30% for an extra 3% is not what we would consider an attractive risk/reward trade. The paradox is that what looks to be the safest asset class today - bonds backed by the full faith and credit of the United States Government - could easily be the riskiest. Holders of longer dated bonds could easily incur major losses if yields simply rise to where they were at the start of the year. The long bond yield has plummeted as money has poured into the government bond market as a ight to safety. The irony is that the government has dramatically stepped up spending and assumed much more risk through their litany of alphabet soup programs and yet their cost of borrowing has declined, thus punishing the very savings that we are trying to induce. Add a huge scal stimulus package and ever widening budget decits on a state and national level, and its not too hard to make a case for higher, not lower government bond yields.

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Government plans to sell $2 trillion of debt are setting bond investors up for losses. On the surface, it appears that nothing remarkable is happening. Yet while nominal yields have declined, the credit risk component of U.S. Treasuries has been on an increasing trend since last year (see chart). In other words, the cost of insuring against a U.S. Government default has risen substantially. In fact, in December, the cost to hedge against losses on U.S. Treasuries surpassed the price of default protection on bonds from Campbell Soup! Imagine that . . . markets think a soup company is more likely to repay their debt than Uncle Sam.

The Kindness of Strangers

So yields are at record lows at the same time we are hearing that the Japanese have asked the Treasury to consider issuing debt in Yen. Why? Because Japanese economists are worried that as a result of all the rescues, bailouts and other stimuli the U.S. Government is taking on, the Dollar will decline to such an extent that their loans will be paid back in a devalued currency. Issuing Treasuries in foreign currencies may be the only way the U.S. Government can keep Japan and China invested. Now where have we heard of this phenomenon before? Oh yes - Brady Bonds. Apparently, the creditworthiness of the U.S. is being compared to that of Latin America in the 1970s and 1980s. This would not be the rst time the U.S. had to follow this path. During the oil crisis in the 1970s, the Carter administration denominated Treasuries in German Marks and Swiss Francs. Will the Carter Bonds be reborn Obama Bonds? Mr. Obama may not have a choice and has recently suggested that Americans get used to trillion-Dollar decits for years to come. Politicians hope that decit nancing will be the way to stimulate the economy. But someone has to buy all those bonds. Since 2004, 94% of new buyers of U.S. Government debt have been foreigners. China has bought more than $1 trillion in American debt which has helped keep interest rates low, but reduced Chinese enthusiasm for these bonds would have the opposite effect. The only guaranteed aspect of all these programs is that there will be a lot more Treasury bonds issued in the face of slackening demand by international investors. 2

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The kindness of strangers remains paramount for this game to continue. But the U.S. is in a very difcult position having to nance an enormous decit without being able to offer competitive yields. Our impression is that were likely to observe one of two things. If the Dollar holds steady, Treasury bond prices are likely to plunge; if Treasury prices hold steady, the value of the Dollar is likely to plunge. For foreign investors holding boatloads of U.S. Treasuries, the recent rally in the U.S. Dollar, coupled with astoundingly low yields, has created a perfect exit opportunity. While we wrote positively about the prospects for a Dollar rally in January of last year (Broyhill Letter Q4-07), now think it is time for at least an interruption in the greenbacks bull market escapade.

A Bubble in Safety?
The panic in the nancial markets has driven bond prices to speculative extremes (see chart below). Unfortunately, unlike the stock market, where hopes and dreams can often sustain speculative markets for years, it is very difcult to sustain speculative runs in bond prices. The stream of payments for bonds is xed and known in advance.

The long-term Treasury market now requires near-depression economic conditions to justify prevailing prices and yields. In the event that the general level of risk aversion among investors eases, either the U.S. Treasury market or the value of the U.S. Dollar will endure disproportionately large losses. Given the level of extension in yields, it would not be difcult to generate losses of say 10% in the 10-year Treasury, and as much as 30% in the 30-year Treasury over a very short period of time. For our part, we continue to prefer Treasury Ination-Protected Securities (TIPS), largely because TIPS prices now reect the prospect of sustained deation over the next decade, in the face of a government that is issuing enormous volumes of liabilities and has nearly doubled the balance sheet of the Federal Reserve over the past 3 months.

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Normally, conventional Treasuries yield more than their ination-indexed brethren because the extra yield is compensation for exposing ones investment to the ravages of ination. Conventional Treasuries only guarantee a nominal yield; TIPS guarantee an ination-adjusted yield. Expecting some level of ination is the normal state of affairs. But these arent normal times, so the yield premium for standard Treasuries has shrunk to almost nothing compared with TIPS. So if you expect ination to one day return (as we do), buying TIPS is a no-brainer, since you currently dont have to accept a lower yield relative to conventional Treasuries and at the same time you receive an ination hedge at no extra cost.

Bottom Line
It helps to remember that the Latin root of the word credit comes from credere to believe, but also to trust. For large sections of the bond market, it is precisely that trust which has disappeared over the last year. The Government is now in the midst of the biggest expansion of monetary and scal stimulus perhaps ever. Although many people welcome the government doing what they can to arrest the decline in the economy and prop up the nancial system - and perhaps it is far better than the alternative - one cannot turn a blind eye to the consequences. It may be that the current round of government intervention will be akin to wetting our pants: At rst it feels warm and comfortable, but after a short while it becomes cold and regrettable. Lets hope that the warm comfortable part lasts for a long time and that we are smart enough to change before the cold and regrettable part takes over. - Christopher R. Pavese, CFA