“Lower for longer.” This phrase, dreaded by many fixed income investors, refers to the likelihood that interest rates will stay low over the long term.
If you’re trying to generate income from your investment portfolio without taking a lot of risk, the steep drop in bond yields over the past six months has probably been a big disappointment. And we see no relief in sight: We believe that 10-year Treasury yields peaked for this business cycle at 3.25% last November, and are likely to remain below 3% for the rest of the year and into 2020.
While the prospect of ongoing low interest rates may present some challenges for income investors, it doesn’t represent a big change. Since 2011, there have only been a handful of times when 10-year Treasury yields were above 3%.
Since 2011, 10-year U.S. Treasury yields have rarely been above 3%
Source: Bloomberg, weekly data as of 5/10/2019. US Generic Govt 10 Year Yield (USGG10YR Index). Past performance is no guarantee of future results.
There are several reasons why yields have remained mostly below 3%:
1. Slowing domestic and global growth
U.S. economic growth appears to be edging down toward the longer-term annual trend rate of 2% to 2.5% that has prevailed since 2000. While gross domestic product (GDP) growth has been above that trend in recent quarters, the boost from tax cuts and government spending appears to be waning. Domestic demand, which accounts for about two-thirds of GDP growth, has been edging lower in recent quarters, suggesting a return to a lower growth trend.
U.S. GDP growth has been stronger than expected, while spending has declined
Source: Bloomberg. Gross Domestic Product (GDP CQOQ Index) and Real Final Sales of Domestic Product (A190RL1Q225SBEA), Percent Change from Preceding Period, Quarterly, Seasonally Adjusted Annual Rate. Data as of Q12019.
Leading indicators point to continued softness in growth in other major countries, as well. Europe’s growth rate has fallen to about 1% in the past year, due to a drop in manufacturing activity and trade. China’s growth rate has slowed, along with much of the rest of Asia.
The OECD Composite Leading Indicators Index has shown slowing growth
Note: The Organisation for Economic Co-operation and Development’s (OECD) work is based on continued monitoring of events in member countries as well as outside OECD area, and includes regular projections of short and medium-term economic developments.
Source: OECD as of March 2019.
As a result of slowing growth, central banks have kept interest rates very low or even negative in many major countries. U.S. government bond yields are significantly higher than those in most other major countries. Consequently, investors looking for positive returns are finding U.S. bonds attractive on a relative basis.
U.S. yields are higher than other major countries’ bond yields
Source: Bloomberg. Data as of 5/13/2019. Past performance is no guarantee of future results.
2. Central bank monetary policy is on hold or easier
Central banks in the major developed countries of the world are either easing or leaning toward easier policy as a result of sluggish growth and low inflation. Nonetheless, yield curves in most major countries are flattening despite negative short-term rates, suggesting that investors see even slower growth and lower inflation going forward. Most significant is that 10-year government bond yields are drifting into negative territory in many countries, signaling that investor demand for relatively safe assets is strong while inflation concerns are low. In that kind of environment, central banks have few alternatives to keeping rates low.
Yield curves for Germany and Japan (3 months to 10 years) have flattened
Source: Bloomberg. German 10-Year (GTDEM10YR Corp) Minus 3-Month Maturity (GTDEM3MO Corp) and Japan 10-Year (GTJPY10YR Corp) Minus 3-Month (GTJPY3MO Corp) Maturity, Percent, Not Seasonally Adjusted. Weekly data as of 5/13/2019.
3. Demographic forces
One of the underlying forces holding down interest rates is aging in the developed world. Consumption tends to slow as a population ages, which results in slower economic growth. Younger consumers tend to spend more, while older people usually save more, increasing the demand for bonds and keeping inflation pressures in check. Japan is the most extreme example of this trend. Its population is not just aging, but also declining, as deaths outpace births. Consequently, its central bank has been fighting deflation for many years with very easy monetary policies, but bond yields remain near zero.
In the U.S., the aging of the workforce has been correlated with declining inflation. As the ratio of young to middle-aged workers has fallen, so have interest rates. Based on population projections, the trend may have hit its trough, but any increase is expected to be modest over the next few years, suggesting limited upside in bond yields.
As the ratio of young to middle-aged U.S. workers has fallen, 10-year Treasury yields and the Consumer Price Index (CPI) have declined
Source: Bloomberg, USGG10 and CPI XYOY, annual averages through 12/2018. OECD historical population data and projections, annual averages, projections 2015-2025. The ratio of 25-to 34-year olds ("young") to 45- to 54-year olds ("middle-aged"). Past performance is no guarantee of future results.
In light of these trends, we believe that the next move by the Federal Reserve is more likely to be a rate cut than an increase, although it may not happen until later this year or next year. We should have more insight into Fed policy soon. In June, the Fed will convene a meeting in Chicago to review its policies, tools and communications strategy. The impetus for the review is concern that inflation and inflation expectations are not responding to the Fed’s policy moves as they have in the past. This has caused some Fed officials to worry that policy may be out of step with the economy.
What’s an income investor to do?
The good news is that investors looking for income can find yields that outpace inflation without taking extraordinary risks, but it does require careful consideration of the tradeoffs between risk and reward in some asset classes. We continue to believe that investors should favor higher-credit-quality bonds over lower-rated bonds, fixed-rate bonds over floating-rate, and strive for diversification.
Yields on some asset classes are above the Fed’s 2% inflation target
Note: Yield to worst is the lowest potential yield that can be received on a bond without the issuer actually defaulting.
Source: Bloomberg Barclays. Indexes representing the investment types are: Bloomberg Barclays U.S. Corporate High-Yield Bond Index (High Yield), Bloomberg Barclays Emerging Markets Local Currency Government Index (EM Local Currency Government), Bloomberg Barclays U.S. Corporate Bond Index (Investment Grade), ICE BofAml Fixed Rate Preferred Securities Index (Preferreds), Bloomberg Barclays U.S. MBS Index (Agency Mortgage-Backed), Bloomberg Barclays Municipal Bond Index (Municipal), Bloomberg Barclays Global Aggregate ex-US Bond Index (International Ex-USD), monthly data as of 5/10/2019. Past performance is no guarantee of future results.
Within the corporate bond market, we favor maintaining average credit quality above BBB (S&P, Fitch)/Baa (Moody’s) level, due to the risk that a downturn in the economy could cause a wave of credit downgrades. We aren’t suggesting that investors avoid the lowest investment-grade tiers altogether, but rather focus on holding enough higher-rated bonds to reduce their portfolio’s overall risk profile. Corporate bonds rated A currently yield about 91 basis points more than Treasuries of comparable maturity, while BBB-rated bonds yield 147 basis points more than a comparable Treasury security (a basis point is one-hundredth of a percentage point, or 0.01%). For most investors, the difference in yield is worth the reduction in risk to move up in credit quality.
For investors with a longer time horizon and the capacity to take more risk, some allocation to high-yield bonds is reasonable, as the coupon income of roughly 6% can provide some offset to the risk of price declines. However, the caveat is that the yield spread versus Treasuries is below the long-term average.
The upside in high-yield bonds may be limited
Note: Option-adjusted spreads (OAS) are quoted as a fixed spread, or differential, over U.S. Treasury issues. OAS is a method used in calculating the relative value of a fixed income security containing an embedded option, such as a borrower's option to prepay a loan. An excess return is calculated for each security in the index as the difference between the security’s total return and the total return on Treasuries in the corresponding duration cell. These excess returns are aggregated to the index level.
Source: Bloomberg. Bloomberg Barclays U.S. Corporate High-Yield Bond Index, Average OAS using monthly data as of 5/10/2019.
Investors willing to hold longer-term bonds may want to consider municipal bonds and/or preferred securities. Unlike the Treasury bond market, the yield curve in the municipal bond market is positively sloped, meaning that long-term yields are higher than short-term yields. Investors receive some compensation for taking on added duration risk. Moreover, on an after-tax basis, AAA-rated longer-term municipal bonds are offering higher yields than Treasuries. Investors in the 24% or higher federal tax brackets should consider the municipal market for allocations to longer-term bonds.
Preferred securities can also provide more income for investors willing to tolerate more interest rate risk—the average coupon rate of the issues in the ICE BofAML Fixed Rate Preferred Securities Index is 5.75%. Most preferreds either have long-term maturities or are perpetual securities with no set maturity date. They tend to be interest-rate sensitive and their prices can be very volatile, but the higher income payments help to compensate for those risks. For a small slice of a portfolio, preferreds could be a way to add income.
We also suggest investors consider shifting from floating-rate investments to fixed-rate investments. Since we doubt the Fed will raise short-term rates much more, if at all, in this cycle, the benefits of floating-rate investments have diminished. We’re especially concerned about bank loan investments, as they are low in credit quality and less liquid than other markets.
Additionally, we suggest some allocation to Treasuries for diversification from stocks. Although yields are quite low, history suggests that Treasuries tend to perform better than most other asset classes when the stock market declines.
Finally, some investors may want to consider generating income by selling assets, using a that harvests some of a portfolio’s gains—including price appreciation—for income as needed.
The prospect for bond yields staying lower for longer means investing for income is likely to remain challenging for the foreseeable future. However, a portfolio of high-quality fixed income investments can still provide positive income and diversification from stocks.
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