Declining Rates in 2019: What Does It Mean for Bond Investors?
Capital markets have been jarred recently by plummeting global interest rates, which have created a unique but difficult investment environment.
Year to date through August, the 2-, 5-, 10-, and 30-year nominal Treasury yields have all fallen 100 basis points or more.
What does this mean for fixed income investors? Are Treasuries and Core Aggregate bond strategies suddenly back in the driver’s seat after recent years of credit outperformance? Should investors make allocation adjustments in light of the recent shifts in bond market pricing?
Bond investments are mostly viewed as the ‘anchor to windward’ of a portfolio. Bonds may not offer the potential for capital appreciation that stocks do, but their possible capital losses are lower, and the overall volatility and risk of fixed income is, therefore, assumed to be lower as well.
Nevertheless, the value proposition for bonds has been challenged lately, especially in the government bond universe. 10-Year US Treasury yields looked unattractive at 2.85% one year ago, yet here we sit today with yields having fallen below 2%!
It’s difficult to comprehend that surge in government bond price appreciation with the US economy still in a relatively healthy state, and it’s even more difficult to justify long term value at these levels. However, in a world mostly devoid of meaningful yield, US Treasuries are in high demand.
As we’ve seen this past year, that demand can spike when investors become leery of risky assets amid policy confusion and deteriorating growth prospects outside of the US.
Reasons to Maintain a Well Diversified Bond Portfolio
Despite the recent outperformance of Treasuries, there are reasons to maintain a well-diversified fixed income allocation.
When viewed in isolation, the high level of volatility in long-term Treasuries this year is unsettling--the ICE BofA Merrill Lynch 10+ Year US Treasury Index standard deviation is 14.28% YTD, which is much higher than 2017’s 4.94% and 2018’s 9.73%.
In fact, this YTD volatility number is higher than in any calendar year since 2009 (only to be outdone modestly in 2008’s global financial meltdown).
So when long Treasury sector performance is adjusted for volatility of returns, longer term results actually look much less compelling.
Below is performance and standard deviation for the BofA Merrill Lynch 10+ Year Treasury, BofA Merrill Lynch 1-10 Year US Treasury, Bloomberg Barclays US Aggregate, and S&P 500 Indices. Since the fall of 2011, a passive long Treasury index portfolio would have generated less than half the performance for near the same level of volatility as the S&P 500.
The growth picture in the U.S. is not as negative as it was in other recent times when yields sharply declined. When 10-Year yields fell in 2011, S&P had announced a negative outlook for the US AAA rating and Europe was wrestling with an unsustainable debt burden in countries like Greece.
Growth in the U.S. that year disappointed at 1.6%. Yields remained at subdued levels through 2012 before spiking again in 2013 with the taper tantrum (GDP growth in 2013 was 1.7%).
This time around, with real growth in the US hovering around 2% and inflation somewhere between 1.5% and 2%, 10-year nominal Treasury yields of 1.5% (a level that existed at one point in August) suggest a negative real yield and dire outlook for growth.
But with unemployment still at historic lows, consumer spending strong, and other economic indicators remaining positive, the data is more optimistic than in 2011. In a situation like this, Treasury outperformance may not last.
Also, a well-diversified government, credit, and international laden portfolio actually has been less volatile than long Treasuries over the last three and ten year periods, while offering strong risk-adjusted performance.
This can be seen in the Sharpe ratios of a diversified bond portfolio relative to the US Aggregate and both the medium and longer-term Treasury indices. Sharpe ratio measures the performance of an investment relative to a risk-free asset after adjusting for risk.
Treasuries are an appealing safe haven for investors in times of market distress, and they remain the bedrock of a fixed income allocation.
However, despite a strong performance run recently, investors would do well to maintain a diversified fixed income portfolio and not overly react to short-term market jolts.
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