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WashingtonWise Investor: Episode 11


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Bond Markets & the Beltway

Interest rates are unlikely to rise this year, the Treasury is offering long (and maybe even ultra-long) bonds, investors searching for yield are taking on more risk, and there are fears that battling the coronavirus may cause China to slow its bond purchases. So what are the expectations for bond markets in 2020?

On this week’s WashingtonWise Investor, Collin Martin, managing director of fixed income strategy at the Schwab Center for Financial Research, joins Mike to offer perspective on a wide range of issues facing the bond markets in 2020. They discuss the Treasury’s motivation to again offer 20-year bonds beginning this spring, and possibly ultra-long bonds in the future, and where such bonds might fit in your portfolio; how investors reaching for greater yield may be taking on increased risk; and how the bond market typically fares during an election year. They also consider whether the coronavirus could impact China’s continued purchase of U.S. Treasuries. Mike also offers his perspective on other news of the week, including a new rule proposal from the SEC that could be a huge benefit to ordinary investors; a contentious hearing on Capitol Hill for one of the nominees to fill an open seat at the Federal Reserve; and the latest news from the 2020 campaign trail.

WashingtonWise Investor is an original podcast from Charles Schwab. If you enjoy the show, please leave a rating or review on Apple Podcasts.

Click to show the transcript

MIKE TOWNSEND: The Treasury Department recently announced that it would begin offering a 20-year bond this spring—the first time such a bond has been issued regularly since 1986. And Treasury has also publicly considered whether there is an appetite for so-called “ultra-long bonds” of 50 years or even 100 years. That leaves two important questions: Why is Treasury doing this? And what should investors make of it?

Welcome to WashingtonWise Investor, an original podcast from Charles Schwab, where we try to cut through the noise and the nonsense of the nation’s capital and help investors figure out what’s really worth paying attention to. In just a few minutes, I’m going to discuss these and other questions about the bond market with one of Schwab’s fixed-income experts. But first, let’s take a look at some of the other stories making news right now.

First off, the coronavirus outbreak remains front-page news. Several analysts have lowered their quarterly and annual economic projections for China, and worries persist about just how much impact that could have on the global and the U.S. economy. Testifying before Congress earlier this month, Federal Reserve Chair Jerome Powell said that the U.S. economy is “in a very good place” but acknowledged that the impact of the coronavirus was still too difficult to assess. The Fed chair said that while he thinks it is “very likely” that there will be some impact, “it’s just too early to say.” And he added that “we have to resist the temptation to speculate on [the impact.]”

Meanwhile, investors were spooked by Apple’s announcement last Monday that it was cutting its sales expectations for the quarter, explaining that its supply of smartphones would be affected by the production slowdown in China, as factories closed and then slowly reopened in recent weeks due to the coronavirus outbreak. And the company conceded that sales in China, which is Apple’s second-largest market after the United States, weren’t going to meet expectations due to the dramatic pullback in consumer spending in China during the outbreak.

The market is now expecting other companies to make similar announcements. Travel and tourism-related companies, including airlines and hotel chains, are already feeling the pinch, and oil prices have taken a hit as well. And supply chain issues will likely plague other large companies across a variety of sectors.

As Fed Chair Powell said, it’s too soon to really know the impact the outbreak will have on economies and on the markets. Our experts at Schwab caution against becoming too defensive but do recommend staying diversified, rebalancing regularly, and maintaining your focus on your long-term financial plan. If you have questions, don’t hesitate to reach out to your financial advisor.

Elsewhere, I want to spend a minute talking about an important new rule proposal at the SEC that could have an enormous positive impact on individual investors. On February 14, the SEC voted unanimously to propose a rule that overhauls the market data system. Market data is the lifeblood of our markets—it’s the information about the bid price and ask price of securities, along with all the details investors want to know about how the market for a particular stock is looking. But the system has heavily favored institutional investors over individual investors for decades. Institutional investors get better information at a faster speed than ordinary investors, and they can and do take advantage of that. The new proposal seeks to level the playing field, by giving all investors the same information and reducing the speed difference. Individual investors, under the proposal, would have access to what is known as “depth of book,” a more robust look at the bids and offers for a particular security, as well as other information.

At Schwab, we’ve advocated for leveling the playing field for literally decades. In fact, our founder, Chuck Schwab, testified about this back in February 2000, 20 years ago this week, telling the Senate Banking Committee that individuals were at an information disadvantage to institutional investors. The SEC’s rule proposal earlier this month seeks to change that equation.

So what’s next? Well, once the rule proposal is formally published, there will be a 60-day public comment period. Now the proposal is nearly 600 pages long, so it will take a while to fully digest. After a period of review, the SEC can vote to finalize the rule or make changes to it—but there’s no specific timeline for how long that process has to take. And there’s always the possibility of a legal challenge, which has become all too common these days when it comes to SEC rules. So this proposal is a long, long way from becoming reality. But we’re encouraged that the SEC appears to be trying to make the system more fair for individual investors.

Finally, the Senate recently held a confirmation hearing for the two nominees for the open seats at the Federal Reserve Board of Governors. Now the Fed is supposed to have seven governors, but it has been operating with only five for a long time now. One of the president’s nominees is Christopher Waller, a long-time economist at the St. Louis Fed. He’s a conventional pick who is widely seen as a shoo-in for confirmation, and his performance before the Senate Banking Committee earlier this month did nothing to change that perception.

Most of the attention at the hearing was focused on the other nominee, Judy Shelton, who most recently was the U.S. executive director of the European Bank for Reconstruction and Development and is currently an economic advisor to President Trump. Shelton’s nomination was much more controversial due to a number of statements and positions she has made or held in the past. At the hearing on February 13, she endured tough questions from Senators of both parties about her past support for the gold standard, her questioning of the role the Federal Reserve plays, and her close ties to the president. After the hearing, three Republican Senators publicly expressed concerns about her nomination—and that’s important because Republicans hold a narrow 13-12 majority on the committee. With Democrats on the committee united in their opposition to Shelton, it would take just a single Republican who opposes her to sink her nomination. There were rumors in the aftermath that the White House might pull her nomination, but that has not happened, and in fact, a White House spokesperson reiterated the administration’s support. A date for the committee vote has not been set yet, but it is expected to take place early next month. That’s when we’ll find out whether one or two of the president’s Fed nominees gets to move on to a final confirmation vote on the Senate floor.

On my Deeper Dive this week, I’m going to explore some of the issues that are impacting the bond market and discuss how investors should be thinking about these developments with my colleague Collin Martin. Collin is a managing director and fixed income strategist with the Schwab Center for Financial Research. He’s been with Schwab for nearly eight years and previously held a similar role at Morgan Stanley. Collin, thanks so much for joining me today.

COLLIN MARTIN: Thanks for having me on the program, Mike.

MIKE: Let me start by asking you about an announcement last month from the Treasury Department that they will begin selling 20-year Treasury bonds this spring. Now it’s been more than three decades since Treasury offered a 20-year bond. So what’s the motivation behind this move by the government?

COLLIN: Part of the motivation likely had to do with the low level of interest rates today. With rates so low, and such a large amount of government debt outstanding, it makes sense to lock in these yields for a long time.

As it stands today, the U.S. Treasury issues securities with initial maturities of 10 years and 30 years, but nothing in between.

When the Treasury initially began discussing new options for its debt issuance, the idea of even longer-term bonds was on the table, like those with maturities of 50 or even 100 years.

MIKE: For the moment, the idea of so-called “ultra-long” bonds in the 50-year or 100-year category seems to be on the back burner. But Treasury has done a lot of research into what the market would be like for these kinds of bonds, and whether there’s an investor appetite for them. So what’s your take on ultra-long bonds? Do you think they will eventually happen?

COLLIN: The idea of ultra-long bonds is likely on the back burner for now, because of insufficient demand.

It’s important to take a step back and consider how the Treasury works and how it issues debt.

The Treasury Department’s primary goal in debt management policy is to finance the government at the lowest cost over time. The Treasury does this by issuing Treasury securities—it issues Treasury bills with maturities as short as four weeks and it issues Treasury bonds with maturities as long as 30 years, with a lot of maturities in between.

And the Treasury issues this debt through auctions. In 2019, there were a total of 322 auctions of individual Treasury securities, with approximately $11.8 trillion in securities being issued last year alone. And the auction sizes are huge. For example, at the end of 2019, Treasury auctioned $42 billion in 13-week Treasury bills.

While that $42 billion seems like a huge number, you have to remember that Treasury has more than $16 trillion, that’s trillion with a T, in marketable debt outstanding.

And this brings us back to the question of issuing ultra-long term bonds, and what the Treasury Department’s goal is. To meet their objective, Treasury issuance needs to be regular and predictable. And feedback from market participants, like the Treasury Borrowing Advisory Committee, cautioned against issuing ultra-long bonds due to a potential lack of demand.

The Treasury needs to consider what the potential investor base looks like. Just because it wants to issue ultra-long debt, doesn’t mean everyone would necessarily want to buy it. And if there were weak demand, that could ultimately lead to higher borrowing costs, which would help negate part of the benefit of issuing those ultra-long bonds today. Now since the Advisory Committee found that there were probably not enough consistent demand over time, that probably would not to allow for regular and predictable issuance. So given that, to us, it seems unlikely we’ll see an ultra-long Treasury bond anytime soon.

MIKE: Well, let’s go back to the 20-year bond for a moment—is that something investors should be considering? How would a 20-year bond fit into a broader portfolio?

COLLIN: We generally suggest investors match their bond investments with their investing time horizon. So if you have a 20-year liability that you’re trying to match, then maybe a 20-year Treasury bond would make sense. Unfortunately the yield will likely still be pretty low, considering the yield of the 30-year Treasury bond has generally been between 2% and 3% for most of 2019 and into 2020.

Now if you had a shorter investing time horizon, a 20-year Treasury probably doesn’t make as much sense. Longer-term bonds have more interest rate sensitivity than shorter-term bonds. The term we use is duration—it’s the measure of that interest rate sensitivity. Now this is important because bond prices and yields generally move in opposite directions. In other words, if a bond’s yield rises, its price should fall, and vice versa. And the higher the duration of a bond, the more sensitive it is to any changes in its yield.

So if you were to invest in a 20-year Treasury, or really, any long-term bond investment for that matter, its price could fall sharply if its yield rose—and more sharply than a Treasury with a lower duration or a shorter maturity.

Now if you hold to maturity, these price fluctuations wouldn’t matter of course, but you’d still see the effect of those price fluctuations on the value of your portfolio.

And then a final point on long-term bonds is that they do provide some of the best diversification benefits for a portfolio, since they tend to have negative correlations with the stock market. So if stock prices were to fall sharply, long-term Treasuries might appreciate in value, helping to offset some of the price declines from your stocks.

MIKE: Well Collin, of course, the reason we are talking about these kinds of bonds at all is because of growing federal budget deficits. Our federal deficit is over a $1 trillion a year already, and it’s not projected to shrink anytime soon. Does issuing these types of products let Congress and the administration off the hook from actually addressing the deficit and the national debt, which is projected to exceed $25 trillion next year?

COLLIN: We don’t necessarily think this lets them off the hook. But we do share concerns about the size of the deficit and the amount of national debt outstanding. We’d prefer that Treasury Department manage the national debt so that it’s sustainable over the long run.

Now there are a few things to consider. Now first, it’s important to look at national debt not just from a total amount outstanding, but also from a relative standpoint, like as a percent of GDP. Now, even as a percent of GDP, it’s high and it’s been rising—it was over 105% as of the second quarter of 2019. But there are other countries that have higher ratios. We would find it troubling, though, if that ratio were to continue to rise.

We’ve also found that, at least with the U.S., there hasn’t been much of a relationship between the level of debt or deficits and the level of interest rates. Consider the amount of debt we already have outstanding, and yields are so low. Those yields are low due to strong demand, so for now, investors don’t really seem to be worried about it. If the government were to meaningfully reduce its borrowings, you know, reduce the amount of Treasury securities outstanding, we’d likely still see strong demand for Treasuries because they’re such a high- quality investment, but there’d be a smaller supply. That could pull our yields even lower, and that’s difficult for investors because our yields are already at, you know, some historically low levels.

So for now we’re not too concerned because demand is so strong, but that might not last forever. Down the road, higher deficits and more national debt outstanding could lead to higher interest rates.

MIKE: Well, Collin, let me ask you a question I’ve been getting from audiences at my events recently. Because China holds over a trillion dollars in U.S. debt, many people worry that the Chinese have too much leverage over the United States. This came up during the trade negotiations over the past year, as concerns mounted that China might use its status as a Treasury creditor to influence the talks. Now, with the coronavirus and its significant impact on China’s economy, I’ve been getting some questions about whether China will need to inject so much money into propping up its own economy that it may buy fewer U.S. Treasuries. Is that a concern, or just a misunderstanding of how this part of the global economy works?

COLLIN: We also get this question all the time, Mike, and we’re not too concerned about this, even though the number does seem staggering. At the end of 2019, China held $1.06 trillion in U.S. Treasury securities.

Now when we get questions about this, there does seem to be a misunderstanding of what it actually means that China holds so much of our debt. They hold our debt just like anyone else holds our debt. It’s not like there’s some sort of side channel where they’re borrowing directly from China or that China is lending directly to us. They simply own a lot of our Treasury securities, and we pay them just like we pay all of our bondholders, by making semiannual interest payments and then repayment at the stated maturity date.

And more importantly, China isn’t even the largest holder of Treasury securities anymore—Japan held $1.2 trillion U.S. Treasuries at the end of last year—that’s about $100 billion more than China.

And as it relates to China, we think it’s still in their best interest to hold U.S. Treasuries. The U.S. dollar is still the world’s reserve currency, and China needs those dollars to participate in global trade—the world generally trades in U.S. dollars. And if they did in fact sell or unload a lot of their Treasury holdings, that could lead to a lower U.S. dollar, or a stronger yuan, and that could hurt their exports because China is such an export-driven economy.

MIKE: That’s great information, Collin. I don’t think a lot of people even realize that China is not the number one holder of U.S. Treasuries.  Well, it’s not just the Treasury Department that has been issuing more and more debt in recent years—we’ve also seen a large increase in corporate debt outstanding as well. Now why is that the case?

COLLIN: Well with interest rates so low, corporations have been issuing more and more debt to take advantage of such low borrowing costs.

Now this contrasts with Treasury issuance. We mentioned this before, but they are meant to be regular and predictable. But if you look at corporate debt issuance, a lot of it has been opportunistic. They’ve been opportunistically issuing more debt. And there’s been growth in many types of corporate debt, but investment grade corporate bonds have seen some of the largest increases.

At the end of 2019, the total amount outstanding of the Bloomberg Barclays U.S. Corporate Bond Index—that’s one of the main corporate bond benchmark indices—the total amount outstanding was $5.3 trillion, compared to just $1.6 trillion at the end of 2004. So that’s an increase of $3.7 trillion in just 15 years, or a jump of 230%.

And if we dig a little deeper, it’s not just the size of the corporate bond market that’s increased so much, there’s been a large jump in the number of “BBB” rated corporate bonds—those are bonds with ratings on the lowest rung of the investment grade spectrum. And they make up more than 50% of the investment grade corporate bond market today.

MIKE: So in other words the search for yield seems to be pushing investors into riskier and riskier corporate debt. Is that sustainable?

COLLIN: We don’t think it’s sustainable, and in fact we have a lot of concerns with the corporate bond market today, especially the riskier parts of the market, like high-yield corporate bonds. High-yield corporate bonds are just a traditional corporate bond, but they have low credit ratings—they have sub-investment grade credit ratings. Think of a credit score for an individual—just like we have scores that matter when we are trying to borrow money, like if we’re applying for a mortgage of some other sort of loan, corporations have credit ratings that are like our credit score.

And what we’re seeing today is that a lot of corporations with low credit ratings are still able to issue debt even if they already have a lot of debt outstanding or even if their profits or revenues are slowing. And that’s likely a product of the low interest rate environment that we’re in today.

Since yields of high-quality investments are so low, a lot of investors are drifting towards riskier investments to earn higher yields.

And that’s allowing more and more firms to issue more and more debt, just because there’s a lot of demand.

There’s actually been a term to describe this phenomenon, and it’s “zombie” companies. And these are corporations that are unable to even cover their debt-servicing costs from current profits over an extended period of time. In other words, they are staying afloat by just refinancing, or rolling over their debt, rather than actually paying it down. Now think of someone with a lot of credit card debt, constantly transferring balances to other cards because of some sort of teaser rate. You know, that’s what we’re seeing with a lot of corporations today, and at some point, these debts need to be refinanced or repaid. And if demand isn’t strong, and if firms can’t refinance, that could lead to an increase in corporate defaults down the road.

MIKE: Well, Collin, there’s one last topic I want to get your thoughts on. It’s an election year, of course, and we’ve talked a lot on this podcast about how the equity markets typically act during a presidential election year, but we haven’t talked at all about how the bond market reacts. So what is the track record of bonds in an election year?

COLLIN: Well, it’s a lot less exciting in the bond market, Mike. But that’s more of a product of how the bond market has performed over time, regardless of whether or not it’s an election year.

Now for starters, it’s tough to really single out “the bond market” since there isn’t really one bond market the way we’d look at the S&P 500® for the stock market. For example, there‘s U.S. Treasury bonds, there are corporate bonds, municipal bonds, just to name a few. There’s a lot of different types of bonds out there.

But given that, we still have some numbers we can look at. There is a common benchmark out there—the Bloomberg Barclays U.S. Aggregate Index. It’s usually called “the Agg,” and it’s considered a high-quality benchmark for the bond market. It’s made up of U.S. Treasuries, agency mortgage-backed securities, agency bonds, and investment grade corporate bonds. It’s a high-quality index, with all constituents generally carrying investment grade credit ratings.

Now since its inception in 1976, so more than 40 years ago, the Agg has only posted a negative total return in three calendar years, and the worst of those returns was just -2.9% in 1994.

So if we look at election years, there have been zero instances of the Agg posting an annual loss.

So while the election will clearly be on a lot of investors’ minds, we don’t really view it as much of driver for the bond market. Rather, we’re looking at Federal Reserve policies as a potential driver of bond performance. We think the Fed’s probably going to keep rates low for the time being, with the potential for an additional rate cut later this year. And if that were to happen, and if we were to see yields do move a little bit lower, now that could push prices higher, potentially resulting in one more year of positive total returns for the Agg. But as always, we have to keep in mind that past performance is no guarantee of future results.

MIKE: Well, Collin, I really appreciate your perspective on a part of the market that I don’t think investors understand quite as well as they do the equity markets. So thank you so much for your time.

COLLIN: Thanks for having me on, Mike.

MIKE: Well, that’s Collin Martin, managing director and fixed income strategist at Charles Schwab.

On my Election 2020 update, things are certainly getting interesting as the race for the Democratic presidential nomination accelerates. As expected, Vermont Senator Bernie Sanders won the Nevada caucuses on Saturday, moving to a narrow lead in the delegate count.

But the real news of the campaign came from someone who wasn’t even really competing in Nevada—former New York City Mayor Mike Bloomberg, whose personal fortune and enormous ad spending have propelled him into the top tier of candidates. Multiple polls in the last week have Bloomberg in the top three, and we saw how seriously other candidates are taking the Bloomberg threat by the way they attacked him at last week’s debate. That was the first time that Bloomberg had appeared on the debate stage, due to a change in the rules for qualification that dropped the requirement that candidates have a certain number of individual donors to their campaign in order to qualify. Since Bloomberg is self-funding his campaign, he has no donors, and thus wasn’t eligible for previous debates.

Now we won’t get a true sense of whether Bloomberg has any real momentum until next week’s “Super Tuesday” voting. On March 3, 14 states go to the polls on the same day, including the two largest prizes in terms of delegates, California and Texas, as well as states like Colorado, North Carolina, and Virginia. Bloomberg has overwhelmed all other candidates with his advertising in those Super Tuesday states—but we’ll have to see whether it pays off.

One other notable development with Bloomberg’s campaign—he released last week a tough plan for financial regulation that surprised some on Wall Street. Bloomberg’s fortune was built through his financial data and financial markets analysis software that has been indispensable to many Wall Street firms for decades. But the policy plan he released last week dispenses with the notion that he might go easy on financial firms if elected president. That plan also includes a call for a financial transaction tax—a small tax of one-tenth of one percent on every stock, bond and derivatives trade. He would phase in the tax, starting at 0.02 percent and increasing over time. In supporting such a tax, he joins other candidates in the race who favor the tax, including Sanders, former South Bend, Indiana Mayor Pete Buttigieg and Massachusetts Senator Elizabeth Warren. But it’s important to remember, as I have said before, that whoever is elected president in November can’t wave a magic wand and implement a new tax—it’s Congress that would have to impose a financial transactions tax, and there’s not a consensus, even among Democrats, about such a proposal. So even though a number of candidates have now endorsed a financial transaction tax, it remains a long way off from actually happening.

Finally, it’s time for my Why It Matters section, where I look at a story you may have missed and tell you why I think it is important. Earlier this month, the president released his budget proposal—the annual kick-off to the clunky budget process in Washington. The reality is that the president’s budget—no matter which party is in office—is really nothing more than a statement of his party’s policy priorities. In fact, this year, the budget numbers are already in place, thanks to a two-year agreement struck last year in Congress.

But what struck me about the budget proposal this year was the quiet admission that annual budget deficits won’t be eliminated until 2035, some 15 years down the line, and even that was dependent upon what many economists believe to be overly optimistic projections on economic growth. And that news was met mostly with a shrug. Fed Chair Jerome Powell chastised Congress during his testimony on Capitol Hill earlier this month for its indifference to budget deficits, and explained that putting the country on a more sustainable path now will help protect the economy if and when a downturn comes. But the so-called “deficit hawks” in Washington seem to be disappearing, and massive budget deficits and a staggering debt now seems to be sparking mostly indifference in both Congress and the public. It’s a worrisome trend. As Powell pointed out in his testimony, the combination of low interest rates and high debt could limit the tools available to combat a downturn in the economy.

Well, that’s it for this episode of WashingtonWise Investor. If you like what you’ve heard, please take a moment to leave us a rating or a review on Apple Podcasts or your favorite listening app. And don’t forget to subscribe so you can be alerted whenever a new episode is available. You can expect our next one in two weeks.

For important disclosures, see the show notes or, where you can also find a transcript.

I’m Mike Townsend, and thanks so much for listening to WashingtonWise Investor. Until next time, keep investing wisely.

Important Disclosures

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

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