Fixed-Income Insights
Do Curve Inversions Hurt Bonds?
Historically, the initial 12 months following an inversion have been generally positive for many asset classes, including short-term corporate bonds and tax-free municipal bonds.
There have been numerous news reports on the slope of the U.S. Treasury yield curve. The current inversion of the Treasury curve, with the 10-year bond offering a lower yield than 3-month Treasury bills, has garnered significant attention, since such inversions have often, but not always, preceded U.S. recessions in the past.
While it may be dangerous to say “it’s different this time,” there are a number of factors to keep in mind. Lord Abbett investment professionals have recently noted that:
- While recessions are commonly preceded by curve inversions, there have been numerous false signals.
- Past inversions were typically much deeper and persisted for longer periods before signaling imminent recession.
- There have often been significant lags between curve inversions and subsequent recessions.
- There are few if any other economic data points signaling a recession in the near term.
One other factor to consider is the absolute level of rates, as illustrated in Chart 1, which compares the slope of the 3-month/10-year Treasury curve to the fed funds target rate.
Chart 1. The Previous Five Yield-Curve Inversions Occurred During Tightening Cycles
Yield on U.S. Treasuries for indicated maturities and fed funds rates (January1, 1977-June 4, 2019)
Source: Bloomberg. The historical data are for illustrative purposes only, do not represent the performance of any specific portfolio managed by Lord Abbett or any particular investment, and are not intended to predict or depict future results. Investors may experience different results.
Past performance is not a reliable indicator or guarantee of future results.
Going in reverse chronological order, the previous curve inversions in 2006, 2000 and 1988 occurred during tightening cycles when the U.S. Federal Reserve Board (Fed) increased their target fed funds rate to 5.25%, 6.50% and 9.75% respectively.
Turning the clock back further, the Fed had tightened overnight rates to 20.0% in 1980 and 10.0% in 1978 as inflation (as measured by the U.S. Consumer Price Index) reached double digits. Clearly, today’s environment, with the fed funds rate at only 2.50% - and the Fed signaling its intention to pause its rate hikes and potentially begin to cut rates in 2019 - is quite different.
Still, we have had many client inquiries about asset-class performance during previous inversions. Table 1 summarizes how U.S. large-cap equities, the broader bond market, investment-grade and high-yield short-term corporate bonds, and the broad municipal bond market have fared following the previous three inversions.
Table 1. The Initial 12 Months Following the Last Three Inversions Were Positive for Many Asset Classes
12-month returns of selected indexes following the last three yield-curve inversions on dates indicated
Source: Bloomberg. Barclays Aggregate = Bloomberg Barclays U.S. Aggregate Bond Index, which represents the U.S. investment-grade fixed-rate bond market. Short-term corporates = ICE BofA/ML 1-3 Year U.S. Corporate Index. Short-term high-yield corporates = Bloomberg Barclays U.S. Corporate 1-3 Year High Yield Bond Index. Municipal bonds = Bloomberg Barclays Municipal Bond Index. The historical data are for illustrative purposes only, do not represent the performance of any specific portfolio managed by Lord Abbett or any particular investment, and are not intended to predict or depict future results. Investors may experience different results.
Past performance is not a reliable indicator or guarantee of future results.
It’s difficult to draw direct comparisons to past periods since there have only been a few instances—just three periods in the past 35 years—with each period having its own unique circumstances and exogenous factors. For example, the three inversions listed in the table were followed by the bursting of the housing bubble in 2008, the tech and telecom bubble in 2000, and the Gulf War and oil price spike in 1990. These events led to very difficult economic environments and periods of negative performance for many risk assets—in some cases a few years after the initial curve inversion.
However, as the table illustrates, the initial 12 months following the last three inversions were generally positive for many asset classes, including short-term corporate bonds and tax-free municipal bonds. As we all know, past performance is no indication of future results.
Elsewhere on lordabbett.com, we have noted that most data points from leading economic indicators and broad financial conditions contradict the negative signal coming from the shape of the yield curve and suggest the end of the economic expansion is not on the near term horizon. As such, we believe equity and credit-sensitive fixed- income sectors should continue to fare well.
The current environment is very different from the conditions of previous inversions. We believe there is no need to overreact and change portfolio positioning based on a single signal—one that has been demonstrated to be an unreliable predictor of economic performance.
A Note about Risk: 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. Fixed-income investments are subject to various other risks including changes in credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications and other factors. Lower-rated securities are subject to greater credit risk, default risk, and liquidity risk. Credit risk is the risk that debt issuers will become unable to make timely interest payments, and at worst will fail to repay the principal amount. Although U.S. government securities are guaranteed as to payments of interest and principal, their market prices are not guaranteed and will fluctuate in response to market movements. There is no guarantee that these investment strategies will work under all market conditions or are suitable for all investors and each investor should evaluate their ability to invest long-term, especially during periods of downturn in the market.
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.
Statements concerning financial market trends are based on current market conditions, which will fluctuate. There is no guarantee that markets will perform in a similar manner under similar conditions in the future. Past performance is not a guarantee or a reliable indicator of future results.
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.
A bond yield is income earned from a bond. In cases where the bond pays periodic interest, the yield equals the interest collected. Where a bond is sold at a discount on the par value, it equals the difference between the purchase price and amount received on the bond’s maturity date, otherwise known as the yield to maturity.
Duration is the change in the value of a fixed-income security that will result from a 1% change in market interest rates. Generally, the larger a portfolio’s duration, the greater the interest-rate risk or reward for underlying bond prices.
Term premium is a gauge of the level of risk inherent in holding a longer-term bond versus a series of shorter-term securities. It represents the estimated risk embedded in a longer-maturity bond that is determined by the difference between the actual yield and the “risk neutral” yield (represented by rolling a series of shorter-term securities extending to the same maturity at current rate expectations).
A yield curve is a line that plots the interest rates, at a set point in time, of bonds having equal credit quality, but differing maturity dates.
The ICE BofA/ML 1-3 Year U.S. Corporate Index is an unmanaged index comprised of U.S. dollar denominated investment grade corporate debt securities publicly issued in the U.S. domestic market with between one and three year remaining to final maturity.
Source: ICE Data Indices, LLC (“ICE”), used with permission. ICE PERMITS USE OF THE ICE BofAML INDICES AND RELATED DATA ON AN "AS IS" BASIS, MAKES NO WARRANTIES REGARDING SAME, DOES NOT GUARANTEE THE SUITABILITY, QUALITY, ACCURACY, TIMELINESS, AND/OR COMPLETENESS OF THE ICE BofAML INDICES OR ANY DATA INCLUDED IN, RELATED TO, OR DERIVED THEREFROM, ASSUMES NO LIABILITY IN CONNECTION WITH THE USE OF THE FOREGOING, AND DOES NOT SPONSOR, ENDORSE, OR RECOMMEND LORD, ABBETT & CO. LLC., OR ANY OF ITS PRODUCTS OR SERVICES.
The Bloomberg Barclays U.S. Aggregate Bond Index represents securities that are SEC-registered, taxable, and dollar denominated. The index covers the U.S. investment grade fixed rate bond market, with index components for government and corporate securities, mortgage pass-through securities, and asset-backed securities.
The Bloomberg Barclays U.S. Corporate 1-3 Year High Yield Bond Index is the 1-3 year component of the Bloomberg Barclays U.S. Corporate High Yield Bond Index. It is a market value-weighted index which covers the U.S. non-investment grade fixed-rate debt market and is composed of U.S. dollar-denominated corporate debt.
The Bloomberg Barclays Municipal Bond Index is a rules-based, market-value-weighted index engineered for the long-term tax-exempt bond market. The index is a broad measure of the municipal bond market with maturities of at least one year. To be included in the index, bonds must be rated investment-grade (Baa3/BBB- or higher) by at least two of the following ratings agencies: Moody's, S&P, Fitch.
The S&P 500® Index is widely regarded as the standard for measuring large cap U.S. stock market performance and includes a representative sample of leading companies in leading industries.
Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.
The credit quality of the securities in a portfolio are assigned by a nationally recognized statistical rating organization (NRSRO), such as Standard & Poor’s, Moody’s, or Fitch, as an indication of an issuer's creditworthiness. Ratings range from 'AAA' (highest) to 'D' (lowest). Bonds rated 'BBB' or above are considered investment grade. Credit ratings 'BB' and below are lower-rated securities (junk bonds). High-yielding, non-investment-grade bonds (junk bonds) involve higher risks than investment-grade bonds. Adverse conditions may affect the issuer's ability to pay interest and principal on these securities.
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