Navigating Headwinds in the U.S. Bond Market
Yield’s Up, Now What?
The 10-year U.S. Treasury yield breached the 2.9% level this week, as investors became wary of fiscal stimulus, inflation, and rising deficits.
Figure 1: 10-Year U.S. Treasury Yield
Source: Bloomberg, 2/13/18.
In 2017, short-term Treasury yields in the U.S. moved sharply higher in conjunction with three Federal Reserve (Fed) rate hikes. However, yields on longer-term bonds were more stable, due to robust foreign demand and contained inflation, resulting in a flattening yield curve. Today, the picture looks quite different.
As we look at the fixed-income landscape for 2018, we see several likely storm clouds—and opportunities—for investors.
Further Headwinds Forecasted
We see shifting supply/demand dynamics exerting upward pressure on bond yields:
Increased Supply Falling Demand
|Increased Supply||Falling Demand|
Collectively, an increased supply of bonds, paired with a reduced demand, may drive prices lower, offsetting some or all of the coupon income bondholders receive.
Choppy Waters for Income-Generating Assets?
While it’s true that investment-grade and high-yield corporate bonds offer a yield premium versus U.S. Treasurys, the difference has shrunk considerably and is now near the lowest level since the Great Financial Crisis of 2008. There is not much cushion to absorb a rise in Treasury bond yields, so further moves raise corporate yields higher as well.
Figure 2: Investment-Grade and High-Yield Spread to Treasury
Source: Bloomberg, 2/13/18. A yield spread is the percentage difference in the current yields of various classes of high-yield bonds compared against Treasury bonds in percentage terms. Investment Grade is represented by Bloomberg Barclays U.S. Corporate Bond Index Option-Adjusted Spread; High Yield is represented by Barclays High Yield Bond Index Option-Adjusted Spread. An investment cannot be made in an index. Past performance is not indicative of future results.
Seeking to mitigate the effects of rising rates may be prudent in the current environment. Trimming an allocation to fixed income is one way to accomplish this, as is shifting into shorter-maturity bonds or bond funds.
History has repeatedly shown that markets are notoriously difficult to predict. Therefore, it would be ill-advised to dramatically depart from a strategic allocation to fixed income that is consistent with an investor’s long-term goals. Nevertheless, a modest shift away from bonds and toward stocks, especially companies outside the U.S., may be appropriate given current valuations and the improving global economic environment.
However, economic and financial market conditions should be closely monitored, with an eye toward reallocating assets back to fixed income, when pricing is more attractive and the global economy begins to lose some of its current momentum.
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Index performance is shown for illustrative purposes only and does not predict or depict the performance of the Funds. Indices are unmanaged, include the reinvestment of dividends, and cannot be purchased directly by investors. Past performance does not guarantee future results.
Barclays Capital U.S. Corporate High Yield Bond Index – The index is representative of the universe of fixed-rate, non-investment grade debt.
Bloomberg Barclays U.S. Corporate Bond Index –The index measures the investment-grade, fixed-rate, taxable corporate bond market.
A credit spread is the difference in yield between two bonds of similar maturity, but different credit quality.
The financial crisis of 2007–2008, also known as the global financial crisis and the 2008 financial crisis, is considered by many economists to have been the worst financial crisis since the Great Depression of the 1930s.
A foreign exchange hedge (also called a FOREX hedge) is a method used by companies to eliminate or “hedge” their foreign exchange risk resulting from transactions in foreign. This is done using either the cash flow hedge or the fair value method.
S&P 500 Index is an index of 505 stocks issued by 500 large companies with market capitalizations of at least $6.1 billion.
A yield curve is a curve on a graph in which the yield of fixed-interest securities is plotted against the length of time they have to run to maturity.
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