The case for higher bond yields and what to do about it
- 10-year Treasury yields broke 3% a few weeks back, hitting the highest level in five years – before dropping back.
- Underlying economic conditions, rising inflation, and supply/demand dynamics all point to another wave higher in bond yields.
- Remain underweight fixed income within multi-asset portfolios. Favor inflation protection through alternative assets.
Higher bond yields still
The 10-year U.S. Treasury yield broke above the 3% level, hitting the 2013 highs during the Fed taper tantrum. Shortly thereafter, bonds rallied in response to Italian political drama. We have expressed (and continue to express) high-conviction that yields were heading higher for many reasons – three of which we will highlight: (1) rising inflation, (2) the fed rate cycle, and (3) an adverse shift in supply/demand.
- Rising Inflation: Tight labor markets, rising crude oil prices, trade tension, and durable economic growth support our view that the Consumer Price Index (CPI) should continue to rise in the months ahead.
- Fed Rate Cycle: Investor expectations have fallen into alignment with the Fed’s estimates of interest rates for 2018 and most of the expected rise in 2019. Treasury yields are likely to follow that path.
- Supply/Demand Shift: Issuance of new bonds has increased to fund the rapidly growing federal budget deficit. At the same time, the Fed is reinvesting significantly less of the proceeds from maturations of bonds on their balance sheet and coupon interest received.
What to do about it?
There is plenty of support for the strategic case of including alternatives in a portfolio. Including alternatives in an asset allocation during the last 15 years, improved risk-adjusted returns (figure 1).
Risk return tradeoff
Source: Bloomberg, as of 4/30/2018. Returns are calculated monthly over the last 25 years. Volatility is a measure of risk using the standard deviation or the dispersion of a set of data from its mean. Large cap equity is represented by the S&P 500 index. The Barclays Agg is represented by the Bloomberg Barclays U.S. Aggregate Bond Index. The Hedge fund index is represented by the HFRI fund weighted composite index. Past performance is no guarantee of future results. An investment cannot be made directly into an index.
We believe that there is also a tactical opportunity in alternative investments including commodities and liquid alternatives. If you believe in the limited prospects for bonds in this environment of rising inflation and a rate hike cycle, then using a portion of your fixed-income budget to invest in liquid alternatives may be appropriate.
Rolling quarterly correlation with inflation
1998 – 2018
Source: Thomson Reuters Datastream, as of 6/6/2018. Correlation is a statistical measure of the strength between the movement of two variables in this case the asset class and inflation. The movement is rolling quarterly returns. A correlation of -1.0 indicates a perfect negative correlation, while a correlation of 1.0 indicates a perfect positive correlation. A correlation of 0.0 indicates zero or no relationship between the movement of the two variables. Commodities = GSCI total return index, Treasuries = Barclays US Treasury index, Equities = the S&P 500 index, and Alternatives = HFRI Fund of Funds index. Past performance is not an indication of future results an investment cannot be made in an index.
Alternative investments have historically exhibited positive correlation to inflation. Additionally, given the potential for lower expected return on bonds, one’s opportunity cost of investing in alternatives (i.e. return difference) is potentially lower.
Inflation and rising rates will likely bode poorly for bonds for some time ahead. Investors may want to consider using a portion of fixed income to invest in liquid alternatives.
Opinions expressed are current opinions as of the date appearing in this material only. The information and opinions contained herein are for general information use only. New York Life Investments does not guarantee their accuracy or completeness, nor does New York Life 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 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 these materials will be realized. Past performance is no guarantee of future results.
All investments are subject to market risk, including possible loss of principal. There is no assurance that the investment objectives mentioned will be met. Diversification cannot assure a profit or protect against loss in a declining market.
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.
A portion of a municipal fund’s income may be subject to state and local taxes or the Alternative Minimum Tax. Funds that invest in bonds are subject to interest-rate risk and can lose principal value when interest rates rise. Bonds are also subject to credit risk, in which the bond issuer may fail to pay interest and principal in a timely manner.
Liquidity risk is the risk that certain securities may be difficult or impossible to sell at the time that the seller would like or at the price that the seller believes the security is currently worth. The Fund may not be able to pay redemption proceeds within the allowable time period because of unusual market conditions, unusually high volume of redemptions, or other reasons. To meet redemption requests, the Fund may be forced to sell securities at an unfavorable time and/or under unfavorable conditions.
Alternative investments are speculative, entail substantial risk, and are not suitable for all clients. Alternative investments are intended for experienced and sophisticated investors, who are willing to bear the high economic risks of the investment. Investments in absolute return strategies are not intended to outperform stocks and bonds during strong market rallies. Hedge funds and hedge fund of funds can be highly volatile, carry substantial fees, and involve complex tax structures. Investments in these types of funds involve a high degree of risk, including loss of entire capital.
Treasury Securities are backed by the full faith and credit of the United States government as to payment of principal and interest if held to maturity.
The 10-year Treasury note is a debt obligation issued by the United States government with a maturity of 10 years upon initial issuance. A 10-year Treasury note pays interest at a fixed rate once every six months, and pays the face value to the holder at maturity.
Barclays 5-7 Year US Treasury Bond Index measures the performance of US Treasury securities that have a remaining maturity of at least five years and less than seven years. An investment cannot be made directly in an index.
Bloomberg Barclays U.S. Aggregate Bond Index is an unmanaged market value-weighted performance benchmark for investment-grade or better fixed-rate debt issues, including government, corporate, asset-backed, and mortgage-backed securities, with maturities of at least one year.
Commodity refers to investments in instruments and companies that are susceptible to fluctuations in certain commodity markets. Any negative changes in commodity markets (that may be due to changes in supply and demand for commodities, market S-4 events, regulatory developments, or other factors) could have an adverse impact on those companies.
The Consumer Price Index (CPI) is a measure that examines the weighted average of prices of a basket of consumer goods and services, such as transportation, food and medical care. It is calculated by taking price changes for each item in the predetermined basket of goods and averaging them.
The efficient frontier is the set of optimal portfolios that offers the highest expected return for a defined level of risk or the lowest risk for a given level of expected return. Portfolios that lie below the efficient frontier are sub-optimal because they do not provide enough return for the level of risk.
The HFRI Asset Weighted Composite Index is a global, asset-weighted index comprised of over 1,500 single-manager funds that report to HFR Database. Constituent funds report monthly net of all fees performance in US Dollar and have a minimum of $50 Million under management or a twelve (12) month track record of active performance. The HFRI Asset Weighted Composite Index does not include Funds of Hedge Funds. The constituent funds of the HFRI Asset Weighted Composite Index are weighted according to the AUM reported by each fund for the prior month.
HFRI Hedge Fund of Funds Index – Fund of Funds invest with multiple managers through funds or managed accounts. The strategy designs a diversified portfolio of managers with the objective of significantly lowering the risk (volatility) of investing with an individual manager. The Fund of Funds manager has discretion in choosing which strategies to invest in for the portfolio.
S&P 500 Index is an unmanaged index and is widely regarded as the standard for measuring large-cap U.S. stock market performance.
The S&P GSCI Total Return Index in USD is widely recognized as the leading measure of general commodity price movements and inflation in the world economy. Index is calculated primarily on a world production weighted basis, comprised of the principal physical commodities futures contracts.
Taper tantrum is the term used for the 2013 surge in U.S. Treasury yields, which resulted from the Federal Reserve’s use of tapering to gradually reduce the amount of money it was feeding into the economy.
New York Life Investments is a service mark and name under which New York Life Investment Management LLC does business. New York Life Investments, an indirect subsidiary of New York Life Insurance Company, New York, New York 10010, provides investment advisory products and services. NYLIFE Distributors LLC is located at 30 Hudson Street, Jersey City, NJ 07302. NYLIFE Distributors LLC is a Member FINRA/SIPC.