“The lost decade for bonds has begun.” - Howard Ward, CIO at Gamco Investors
Okay, so here’s the deal. You lend the government money for ten years, and in return they’ll offer you a yield just barely high enough to cover expected inflation over that time period. Sure, you might not gain any real ground, but at least you won’t be losing purchasing power. How does that sound? Are you ready to buy a lost decade?
I am, of course, referring to the current investment appeal of the 10-year US Treasury note. But before I go any further, let’s make a quick distinction between the term “interest rate” and “yield”. While there is no hard and fast rule, the term interest rate often refers to a rate that is fixed in some way by a lender. For instance, the Fed sets short-term interest rates for the economy, a bank sets the fixed interest rate on a mortgage, and a corporation sets the interest rate on their own bonds. But once a security starts trading in the open market, as bonds and securitized mortgages typically do, the yield on a debt investment won’t necessarily match the interest rate. This is because the price of the security can move above or below its initial par value. As such, the yield on an investment typically refers to what an interest-bearing security will earn an investor at a given price.
Consider a 10-year bond that is issued with a $100 par value and a 5% interest rate. Whoever owns this bond will earn $5 a year in interest and will be paid back exactly $100 at maturity, thus if an investor buys the bond at par and holds it to maturity they will earn exactly 5% on their money. However, if at any point over the next ten years the bond is sold to another investor for a price higher than $100 that new investor will earn less than 5% on their money as they will be paying more than $100 but will still only be clipping a $5 coupon and receiving $100 at maturity. In the same way, if the investor is able to buy the bond for less than $100 they will end up realizing a return greater than 5%. This is why we use the term “yield” when referring to where the bond market is currently priced. We are not referring to the underlying interest rate that the bonds themselves pay, but we are referring to the actual yield an investor will realize if purchasing the bond at its current market price and holding it to maturity.
Although there are a wide variety of bonds paying various interest rates and carrying different degrees of risk, the 10 year US Treasury note is the most common benchmark for tracking changes in the bond market’s prevailing yield. So let’s get back to the government’s lost decade offer by looking at the most recently issued 10-year Treasury. This particular note was issued in November of last year and has a maturity date of 11/15/24. It has a par value of $1,000 and pays a 2.25% rate of interest, meaning regardless of the purchase price the bond will pay out $22.50 every year between now and maturity. If, by chance, you were able to acquire this bond for exactly $1,000 you would expect to earn exactly 2.25% on your money for the next ten years. However, if you wanted to buy this bond in today’s market it would cost you closer to $1,051, equating to an annualized yield to maturity of only 1.68% (as of 1/30). As the chart below shows, this yield is quickly approaching the recent low set back in 2012.
One thing that any bond investor always has in the back of his mind is inflation. Whatever “nominal” yield is earned over time is decreased by the prevailing inflation rate in order to arrive at the “real”, or inflation-adjusted yield. No one knows what inflation will be in the future, but we can look at what’s called the breakeven rate on Treasury Inflation Protected Securities (“TIPS”) in order to estimate how much inflation bond market investors are pricing into the market. The chart below adds the 10-year breakeven rate and the implied real 10-year yield to the chart we just examined. Notice that expected inflation over the next ten years perfectly offsets the nominal yield that can be earned on the 10-year US Treasury.
With the prevailing 10-year yield at 1.68% and inflation expectations at the same level, the expected real yield available to an investor looking to buy a 10-year US Treasury note is 0%. This offer equates to a lost decade in which no return will be generated on an inflation-adjusted basis. So I ask again…are you interested in making this investment?
While no one would blame you for quickly passing on this deal, the fact remains that this is where the market is pricing these bonds. Remember, QE is over and the Fed is no longer manipulating the market by buying Treasuries, so 1.68% is the yield that the global investment community has agreed is most appropriate on a 10 year loan to the US government. Let’s look at a few possible explanations of why this rate is still acceptable to so many investors.
Asset Allocation Mandates
While private investors are always free to do whatever they please with their investment capital, there are large institutional investors such as pensions, endowments and sovereign wealth funds that are constrained to following set asset allocation targets. As these funds grow and rebalance their exposure there is perpetually more investment capital destined to be invested in the bond market. In this case bonds have a fixed place in the portfolio that is not added and removed in response to what prevailing yields might be, thus the investor is somewhat indifferent to the fact that real yields are so low right now.
Foreign Investors Don’t Have Any Better Options
Foreign investors, particularly those in Europe and Japan, have been gobbling up US Treasuries like they’re going out of style. The chart below reveals why. Both of these regions have been fighting deflationary forces and struggling to gain economic momentum. Their central banks have responded by ramping up quantitative easing even as the US Fed has been winding its program down. This has depressed bond yields to historic lows, and in several countries investors are even accepting negative yields on bonds with maturities as high as five years out. Although in the US we might view a 1.68% 10-year yield as meager, to these investors it represents a premium.
What’s more, the US Dollar has been in a strong uptrend vs most global currencies including the Euro and the Yen. By investing in US bonds these foreign investors not only earn higher yields than they can in their home country, but they capture additional return from the appreciation of the Dollar vs their local currency. This dynamic is creating a self-reinforcing cycle that amplifies the trend for a while, but poses a risk of a dramatic reversal once the music stops.
Expectation Of Even Lower Yields
Some bond investors are not buying US Treasuries because they’re excited about the yield, they are buying them because they are excited about the direction of prices. Jeffrey Gundlach, the widely-acclaimed “Bond King” and one of our favorite fixed income investors, has made headlines with his non-consensus views that yields could be headed even lower in 2015. "The 10-year Treasury could join the Europeans and go to 1 percent. Why not?” he said recently. Other recognizable investors such as Gary Schilling and Harry Dent also fall into this camp.
There are other potential reasons behind low yields including expectations that the Fed might not raise short-term rates as early as expected, various geopolitical risks and concerns over the strength of the global economy (see Mixed Signals and The Inevitability of Higher Rates for more discussion). Regardless of the reason, most investors looking at US Treasuries right now are doing so for short-term tactical reasons, or because they have to fill a mandated spot in their asset allocation strategy. There certainly is not much long-term appeal to buying and holding one of these bonds to maturity.
Given the low prevailing nominal yield and complete absence of real yield we hesitate to rely too much on traditional buy-and-hold fixed income in our current allocations. Our overall exposure to the bond market is extremely light, and we have chosen to allocate a significant portion of our fixed income holdings to unconstrained managers (one of which is Jeffrey Gundlach) that can react tactically to changing market dynamics and proactively manage the risk of rising rates in the future. These managers, along with a handful of well-timed decisions on our part, have led to outperformance vs global bond benchmarks in our client portfolios over the past several years. While we continue to believe that bonds have a place in a well-diversified portfolio, we will be vigilant in navigating the low return environment ahead in an effort to avoid passively resigning ourselves to buying a lost decade.
Author David Houle, CFA is a founding member of Season Investments. He serves as the firm's Chief Compliance Officer as well as sitting on the investment committee overseeing the management of client assets. David spent nearly ten years in various roles primarily managing individual client assets prior to co-founding Season Investments. David graduated with a degree in Finance from Colorado University in Colorado Springs in 2003 and earned the Chartered Financial Analyst (CFA) designation in 2006. David and his wife Mandy have three children and spend most of their free time with friends and family.
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