Interest Rates and the Role of U.S. Treasuries in a Portfolio | Lord Abbett
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Economic Insights

After receiving questions about net-negative Treasury yields and interest rate movement, we take a closer look at how investors may want to think about Treasury risk.

Read time: 4 minutes

Rising interest rates in the US have triggered a flurry of interest after hovering for several months at their lowest levels in history.  While it’s important to keep the relatively small magnitude of the move in context – only 44 basis points (bps) for 10 year US Treasuries from the start of Q4 2020 (0.71%) to the high point of yield on Jan on Jan 11, 2021 (1.15%) – the fact that even this small move can generate investor interest highlights some key issues for investors.  First, with rates at such low levels on an absolute basis, small moves are magnified, and investors have very little income to cushion them against potential losses associated with rising rates.  Second, there are practical limits to how much lower US rates can fall, suggesting a strong return asymmetry in the event of future volatility, and limits on the efficacy of Treasuries as a portfolio hedge.  Finally, there are a number of variables apart from economic fundamentals in the US that can impact the future direction of interest rates.

U.S. Treasuries and Portfolio Allocation

The “zero interest rate policy” of the Fed, and overall low level of interest rates, means that fixed income investments will necessarily play a different role in portfolios than they have in the past.  The efficacy of US Treasuries in a portfolio as either a portfolio diversifier, or as a steady source of income, has been diminished.    While Treasuries proved their worth as a liquidity buffer once again in March of 2021, spiking higher in price even as many other asset classes collapsed, that protection now comes with a cost.  Treasuries no longer distribute meaningful income, and what little they do return can be wiped out with small rate moves.  Indeed, the relatively small move to start 2021 and in Q4 2020 has already resulted in a price decline greater than the yield for longer dated Treasuries.  Even if Treasuries will still rise in price when risk assets fall, the potential magnitude of that move is so small as to be nearly irrelevant.  The benefits of maintaining exposure to Treasuries as a source of liquidity are undeniable, yet many other advantages have largely vanished, and the potential costs have risen.  The upshot is that investors must be far more deliberate with their allocations to Treasury risk than in prior years.

Low Rates and Treasury Yields

One major reason that rates are so low is that central bank activity has directly impacted Treasury yields in several ways, and in doing so has complicated the traditional relationship between economic expectations and Treasury yields.  For example, we now have robust expectations for GDP growth in the US, with inflation expectations near their highest point of the past 5 years.  However, et even after the recent small rise in Treasury yields, 10-year Treasuries still have a lower yield than at any point prior to 2020.  Why?  For one thing, the Fed has reduced the overnight Fed Funds rate to zero, and committed to keeping it there for some time.  While the Fed Funds rate has no direct relationship with longer dated Treasury yields, it does influence investment decisions for other investors.  2-year Treasuries currently price in no hike in the Fed Funds rate for the next 2 years, and 3-year Treasuries yield only slightly more.  This commitment to a prolonged period of a zero Fed Funds rate tends to lower all Treasury yields.  If markets expect no rate hike for 3 years, then longer maturity Treasuries also have reduced expectations, as a 5-year Treasury would only be a 2-year Treasury in 3 more years; a 10 year would only be a 7 year.  But while this idea of committing to low interest rates is an important policy tool for the Fed to lower longer-term yields, there are other important factors.  Japan and many European economies have negative yields, due primarily to the actions of their own central banks.  In a global market, these low yields around the world tend to pull yields in the US lower, also.  Yet the impact of low global yields on US rates is also limited.  For example, yields on 10-year Treasuries were comfortably about 3% in late 2018, while Europe was still contending with negative yields.

Quantitative Easing in 2020

Finally, one major factor in 2020 was the massive expansion of the Fed’s Quantitative Easing (QE) program, in which they purchased a large number of Treasuries and agency-backed mortgages.  The Fed first implemented this program in the wake of the 2008 financial crisis, and steadily grew the size of their balance sheet until the gradual “taper” until 2014.  As (figure 1) shows, the scope of the buying program launched in March of 2020 dwarfed prior market interventions, nearly doubling the size of the Fed’s balance sheet in only a few months.   Moreover, the Fed purchased so many Treasuries as part of this balance sheet expansion that the buying exceeded even the record amount of Treasury issuance for 2020.  This buying resulted in a negative “net” supply of Treasuries into the marketplace, when subtracting Fed purchases and maturing Treasuries from New Issue Treasuries (figure 2).  While difficult to quantify how much of an impact that purchasing had on valuations, there is no question that the impact was real.   

 

Figure 1. Treasury Net Issuance After Accounting for Federal Reserve Purchases
2011 through 2020, with an estimated net supply for 2021

Source: JPMorgan, Federal Reserve, U.S. Treasury. Note: Coupon-bearing debt only. 2020, 2021 are JPMorgan estimates.
 

Figure 2. U.S. Federal Reserve Balance Sheet
Illustrates negative “net” supply of Treasuries when subtracting Fed purchases and maturing Treasuries from new Issue Treasuries, 2002 through 2020

Source: Federal Reserve. Data as of 01/20/2021.
 

In 2021, of course, this trend should reverse.  As federal debt has ballooned from roughly 100% of GDP to more than 130% and growing, Treasury issuance will only continue to grow.  Street estimates of Net Supply for 2021 exceed any prior records by almost 80%.  Investors have legitimate concerns as to how well, and what level, the market will absorb nearly $ 2 trillion in net supply.  As we have seen in other developed economies, such as Japan (with almost twice as large a debt to GDP ratio as the US), a large debt burden does not necessarily push rates higher.  However, markets will need to adjust to this new paradigm, which may not be a smooth process.  Foreign investors may wish for higher yields, while US investors may find alternatives to holding US Treasuries.  Inflation may rise faster than expected, possibly altering the Fed’s commitment to a low Fed Funds rates.  Any number of variables can impact yields; the growing amount of Treasury issuance is one of many known issues, while there may be others receiving less attention.  While it is highly unlikely that we see interest explode higher, given all of the forces keeping them low, even relatively small moves can be painful for investors right now.  Growing treasury issuance without  offsetting buying from the Fed is yet one more variable making Treasuries a riskier investment than many investors may realize.

 

The value of investments in fixed-income securities will change as interest rates fluctuate and in response to market movements. Generally, when interest rates rise, the prices of debt securities fall, and when interest rates fall, prices generally rise. U.S. Treasuries are debt obligations issued and backed by the full faith and credit of the U.S. government. Income from Treasury securities is exempt from state and local taxes. Although Treasuries are considered to have low credit risk, they are affected by other types of risk—mainly interest rate risk (when interest rates rise, the market value of debt obligations tends to drop) and inflation risk. The value of investments in equity securities will fluctuate in response to general economic conditions and to changes in the prospects of particular companies and/or sectors in the economy.       

Forecasts and projections are based on current market conditions and are subject to change without notice. Projections should not be considered a guarantee.

This article may contain assumptions that are “forward-looking statements,” which are based on certain assumptions of future events. Actual events are difficult to predict and may differ from those assumed. There can be no assurance that forward-looking statements will materialize or that actual returns or results will not be materially different from those described here.

A basis point is a financial unit of measurement that is 1/100th of 1%.  

credit spread is the difference in yield between a U.S. Treasury bond and another debt security of the same maturity but different credit quality. 

Fed refers to the U.S. Federal Reserve.

Federal funds rate (Fed funds rate) is the interest rate at which a depository institution lends immediately available funds (balances at the Federal Reserve) to another depository institution overnight. 

Quantitative easing (QE) is a form of unconventional monetary policy in which a central bank purchases longer-term securities from the open market in order to increase the money supply and encourage lending and investment.

Treasuries are debt securities issued by the U.S. government and secured by its full faith and credit. Income from Treasury securities is exempt from state and local taxes.

The information provided herein is not directed at any investor or category of investors and is provided solely as general information about our products and services and to otherwise provide general investment education.  No information contained herein should be regarded as a suggestion to engage in or refrain from any investment-related course of action as Lord, Abbett & Co LLC (and its affiliates, “Lord Abbett”) is not undertaking to provide impartial investment advice, act as an impartial adviser, or give advice in a fiduciary capacity with respect to the materials presented herein.   If you are an individual retirement investor, contact your financial advisor or other non-Lord Abbett fiduciary about whether any given investment idea, strategy, product, or service described herein may be appropriate for your circumstances.

The opinions in the preceding commentary are as of the date of publication and are subject to change. Additionally, the opinions may not represent the opinions of the firm as a whole. The document is not intended for use as forecast, research or investment advice concerning any particular investment or the markets in general, and it is not intended to be legal advice or tax advice. This document is prepared based on information Lord Abbett deems reliable; however, Lord Abbett does not warrant the accuracy and completeness of the information.

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