Navigating Headwinds in the U.S. Bond Market

by: , Managing Director and Senior Portfolio Manager, New York Life Investment Management

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
  • The rising federal deficit should trigger an increase in Treasury security issuance.
  • The Fed plans to continue to reduce its balance sheet at an accelerating rate.
  • The strengthening housing market could boost the supply of agency mortgage-backed securities (MBS).
  • Quantitative easing (QE) tapering and increased foreign exchange hedge (FX) costs may reduce foreign demand.
  • Corporations holding retained, overseas earnings in U.S. debt securities will sell those bonds to repatriate cash.
  • Corporations less likely to purchase bonds with retained, offshore earnings.
  • Rising inflation expectations quash demand, as the purchasing power of future cash flows is diminished.

 

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.

Navigational Tactics

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.

The information and opinions contained herein are for general information use only. MainStay Investments does not guarantee their accuracy or completeness, nor does MainStay Investments assume any liability for any loss that may result from the reliance by any person upon any such information or opinions. Such information and opinions are as of the date of this report, are subject to change without notice, and are not intended as an offer or solicitation with respect to the purchase or sales of any security or as personalized investment advice. There can be no guarantee that any projection, forecast, or opinion in this material will be realized.

About Risk

All investments are subject to market risk, including possible loss of principal. Stocks and bonds can decline due to adverse issuer, market, regulatory, or economic developments. Bonds are also subject to credit risk, in which the bond issuer may fail to pay interest and principal in a timely manner, or that negative perception of the issuer’s ability to make such payments may cause the price of that bond to decline. A bond’s prices are inversely affected by interest rates. The price will go up when interest rates fall and go down as interest rates rise.

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.

MainStay Investments® is a registered service mark and name under which New York Life Investment Management LLC does business. MainStay Investments, an indirect subsidiary of New York Life Insurance Company, New York, NY 10010, provides investment advisory products and services. Securities distributed by NYLIFE Distributors LLC, 30 Hudson Street, Jersey City, NJ 07302.

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Jonathan Swaney

Managing Director and Senior Portfolio Manager, New York Life Investment Management

Jon is a Managing Director and Senior Portfolio Manager with New York Life Investment Management’s Strategic Asset Allocation & Solutions (SAS) Group.  His current focus is

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