Although that rationale may be lacking on a fundamental basis, the current environment of aging baby boomers and slow global economic growth continues to provide fundamental grounds that should keep long-term interest rates near historically low levels. Monetary policy, particularly the Federal Reserve’s pledge to keep the fed funds rate at exceptionally low levels through at least late 2014 and its various quantitative easing initiatives, should also continue to anchor long-term interest rates.

These factors, however, do not mean that Treasury yields will be immune from periods of volatility. While there are a few scenarios that could lead to periods of turbulence in long-term Treasury yields, this may not translate to volatility in securities that are more aligned with corporate credit fundamentals. (See Table 1 for return correlations between Treasuries and corporate debt securities.)

One of the common threads throughout the current atmosphere of uncertainty relates to the pervasive inaction among policy makers. In Europe, there has been inaction in terms of enhancing the fiscal cohesion among countries in the European Union. In the United States, the inaction also relates to a fiscal situation that, if unaddressed, could push the country into recession and/or drive the country’s debt levels up to about 70% of gross domestic product by the end of 2012, which would be the highest ratio since just after World War II.⁶

While no one will mistake the United States for the peripheral countries in Europe, rising debt levels need to be financed, conceivably, with more debt. This indicates that the supply of U.S. Treasuries is set to rise for the foreseeable future.

Another outcome of the U.S. political impasse could be another downgrade of its credit rating, particularly if the previously scheduled sequestration that is part of the looming “fiscal cliff” is delayed, postponed, or ignored. Standard & Poor’s downgrade of the U.S. credit rating in 2011 was a clear impetus for volatility, yet the declines came in equity indexes and Treasury yields as investors sought the safety of U.S. government debt amid the uncertainty.

However, Fitch Ratings and Moody’s Investors Service currently have “negative” outlooks on their triple-A credit ratings of U.S. debt, with both agencies citing lack of plans to reduce the federal deficit and the political atmosphere of inaction as factors that could contribute to their respective downgrades.⁷ And another downgrade could affect the demand for Treasuries from buyers who are only able to hold triple-A securities as deemed by at least two ratings agencies.

These two issues—the potential need to issue more debt to finance growth deficits and a potential disruption in the buyer base for Treasuries—might create a supply/demand imbalance that could lead to periods of volatility in long-term interest rates. This scenario could become exacerbated if the Fed, which has been the largest recent buyer of Treasury securities, were to also limit its future participation in the market.

Could this potential scenario of volatility also affect corporate credit securities in a similar way? That may be unlikely, given that corporate credit metrics have strengthened in the low-rate environment, while sovereign finances have generally deteriorated. One reflection of this improvement in corporate credit fundamentals is that 67% of the high-yield bonds and floating-rate loans issued during the past three years have involved refinancing transactions,⁸ which can strengthen corporate credit profiles by reducing interest expenses and/or extending maturities.

If long-term Treasury yields were to increase from their current levels, thus potentially making them more attractive to some investors, demand for corporate debt would likely remain high as well. This takes into consideration that high-yield credit spreads remained above their long-term averages as of July 31, 2012,⁹ while the expected high-yield default rate is expected to remain at or below 2% for the next two years, compared with the long-term average of slightly more than 4%.¹⁰ Thus, riskier parts of the corporate bond market might continue to provide a relatively high level of income in an environment where the risks are expected to remain below their long-term averages.

Of course, there are other scenarios that could fuel volatility in long-term rates as well, including one where the risk of insolvency among the peripheral European countries and their banks is mitigated from an investment standpoint. In addition, if U.S. economic growth gains momentum while the country’s fiscal issues are gradually addressed, this could also lead to some turbulence in long-term interest rates.

One indicator of potential economic growth that could have a broader effect on Treasury securities is the continuing increase in bank loan activity. For example, in its July survey of bank loan officers, the Fed stated that not only did U.S. banks ease their lending standards but they also did so in an environment of improving demand as European banks withdrew from the market.¹¹ This has led to an environment where U.S. banks are lending the most since June 2009.¹²

The increase in U.S. bank lending as economic growth continues, albeit slowly, might be reflected in an increase in the velocity of the money supply, which could be an inflationary signal. If more banks regard loans as an effective way to deploy capital, this could also mean that they use less of their capital to hold Treasury securities.

Investors seeking to shy away from Treasury or agency debt might believe they are doing so by avoiding strategies that explicitly state that they are purchasing the securities. But investors could still have considerable exposure to the two asset classes if they own a fund that is benchmarked to the Barclays U.S. Aggregate Bond Index, 77% of which consisted of Treasury, agency, and agency mortgage-backed securities as of July 31, 2012.¹³ Therefore, even if a strategy had an underweight position in those asset classes, it could have significant exposure to Treasury and agency securities.

As investors contemplate the conditions for fixed-income strategies, they will undoubtedly consider how long-term interest rates might respond to certain developments. While these deliberations might include scenarios with periods of volatility, investors might also consider how corporate credit securities might, or might not, be affected during these periods.