by Neuberger Berman Research
July 2012 – Investment Strategy Group
Despite hitting record lows earlier in the year, the yields on U.S. Treasury bonds continue to tumble. The 10-year rate ended last month at 1.62%, materially below the long-time monthly record low of 1.95% set in January 1941. Yields for 10-year Treasury Inflation-Protected Securities (TIPS) have been persistently negative since the fourth quarter of 2011 and continue to trend lower, implying that investors are paying increasingly higher prices for the relative safety these investments are supposed to provide. In this edition of Strategic Spotlight, we consider why yields continue to decline and the implications for investors.
A Mystery, But Is It?
Yields on long-term Treasuries have been declining since the 1980s, when they peaked along with inflation. Since the financial crisis of 2008, the continued reduction in Treasury yields has at times perplexed even the most astute investors. One prominent bond guru famously avoided them in 2010 to the detriment of his portfolio, and pundits who prematurely declared the imminent “death” of bonds couldn’t have been more wrong. In recent years, yields have moved even lower even though inflation has held fairly steady.
Over the longer term, nominal yields for long-term Treasuries generally follow inflation levels and growth expectations. When inflation rises, nominal yields typically rise to compensate for the erosion in purchasing power and, similarly, if growth expectations rise, the increase in attractive investment opportunities in the economy tends to result in rising real (after inflation) interest rates (see Figure 1). Oddly enough, inflation expectations (as implied by the difference between the nominal 10-year Treasury yield and TIPS yield) have held steady at around 2% and the decline in nominal rates has been driven mostly by declining real yields—all in the face of a positive, albeit slow, growth environment.
REAL YIELDS AND GDP TEND TO MOVE TOGETHER
Source: Factset.
So, what explains this somewhat unusual phenomenon? Since the onset of the financial crisis, bond purchases by the Federal Reserve have increased as it has implemented unconventional monetary policies, specifically quantitative easing and maturity extension programs (known to most as Operation Twist). Through these measures, which have tended to lower long-term interest rates, the Fed has sought to stimulate the economy and reduce unemployment at a time of low inflation. Another pressure on rates has come from foreign demand for Treasuries, which has generally been very strong, especially during periods of heightened market anxiety. In recent months, slowing purchases by emerging market central banks have been offset by flight-to-quality demand from European investors, who have also driven the nominal rates on certain German, Dutch and Danish bonds to negative levels. Meanwhile, U.S. investors have shown a lack of appetite for risk as flows to bond mutual funds have outpaced those into equities.
How Low Can Rates Go?
In theory, there is no bottom for bond yields. Declining inflation and continued risk aversion have historically caused nominal rates to fall. Real yields have been significantly negative in certain time periods, although admittedly when inflation was higher than today. Figure 2 shows that there have been two key periods since the 1920s in which real rates where very negative—during the Great Depression and World War II era, and in the 1970s when inflation spiked along with oil prices. Should global economies falter in the coming months, it’s possible that interest rates could move In theory, there is no bottom for bond yields. Real yields have even been significantly negative in certain time periods. lower (even turning negative on the short end), especially if the Fed engages in another round of asset purchases.
REAL RATES HAVE 'GONE NEGATIVE' IN THE PAST
Source: Factset.
Better Opportunities Elsewhere
It should be noted, however, that there are major risks in holding Treasuries with little to no yield. An end to the continued bull run in Treasuries would imply a reversal of some factors supporting it now, such as low inflation, deteriorating growth expectations and worsening prospects for the eurozone debt crisis. With global central banks launching unprecedented levels of monetary easing, potentially higher levels of inflation could hamstring the Fed’s ability to continue asset purchases – causing both inflation expectations and real yields to go higher. In addition, investors may realize that Treasuries might not be as “risk-free” as they assumed, particularly as the debate over the U.S. federal budget deficit intensifies later this year.
While interest rates could still move lower in the short term, we believe that the return profile for the asset class is skewed to the downside, especially given our base-case assumption of low but positive growth. We advise caution in holding excess levels of Treasuries and believe that other assets, such as high yield fixed income and high-quality U.S. equities, could be more attractive in this environment. Similar to buying tech stocks in the late 1990s with no sales and earnings, buying today’s Treasuries with minimal yields could prove hazardous for investors.
*Source: Factset
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