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Fixed-Income Insights

Once thought to be “safe havens,” developed-country government bonds today may prove riskier than many investors are prepared for, and the return for assuming that risk is not commensurate.

Investors in government debt may want to reevaluate the risks of what they believe are their “safe” investments, i.e., government securities. The combination of slow global growth and low interest rates has created a paradox whereby a government’s credit rating may be declining as the volatility of its debt increases and the yield it offers investors falls below inflation. The risks to a portfolio are further increased to the extent investors extend maturity to capture more attractive yield. A better understanding, then, of the risks of owning government bonds in today’s economic and rate environment may help avoid unpleasant performance surprises that could unfold over the next few years.

What Credit Risk?
Most investors expect little if any credit risk when purchasing government debt of developed countries. In fact, though, sovereign debt ratings have been adjusted lower with surprising frequency over the past few years, often without any compensating adjustment in yield. In the past 12 months, for example, Japan, France, Austria, Finland, and the United Kingdom are among countries whose debt has been downgraded—yet yields continue to decline. Investors in this situation accept more risk, but get less in return.  

Meanwhile, the United States has avoided any downgrade since Standard & Poor’s (S&P) reduced the nation’s credit rating in 2011; but a change in U.S. leadership and congressional control this fall could, once again, lead to the budget gamesmanship that produced S&P’s shift in 2011. Such political uncertainty combines with continued slow growth (the frequent driver of sovereign downgrades) to increase the possibility that the United States may yet be subject to additional credit downgrade. If that were to happen, yields might not adjust higher. But such a bellwether event of a U.S. downgrade could prompt investors to reassess the risks and rewards of developed country debt, thereby reversing the yield decline that investors have enjoyed for so long.

Unintended Volatility
A more definitive risk of government debt is its interest rate risk, or the level of volatility. By definition, lower interest rates on the same maturity debt create greater volatility. Thus the general decline in interest rates translates into unintended greater risk for investors, with less return, even though they maintain the same maturity profile. For instance, according to Citigroup’s Yield Book, the modified duration of 9.25 on a 10-year U.S. Treasury yielding 1.5% today is meaningfully higher than the modified duration of 8.37 on a 3.5% 10-year Treasury in 2009. Yields have fallen significantly, from 3.5% to 1.5%, yet the risk, or volatility, of the investment is 10% greater. In risk/reward terms, an investor in 10-year U.S. Treasuries received 42 basis points (bps) per unit of duration risk in 2009, but now receives only 16 bps for that same investment.

The portfolio risk is compounded to the extent investors have extended maturity to capture more yield. Today’s relatively flat yield curve forces investors to absorb measurably more risk while adding modest amounts of yield. Extending maturity from 10 years to 30 years today increases yields on U.S. Treasury investments by 75 bps, from 1.5% to about 2.25%. The level of volatility, or modified duration, jumps from 9.25 to 21.74. Investors who have extended maturity in an attempt to maintain yield likely have fallen far short of their yield target yet increased portfolio volatility more than they realize.

Ignorance, So Far, Has Been Bliss
The decline in rates over the past few years likely has left investors unaware of the additional risk in their portfolios. The higher duration has improved portfolio returns, as rates have declined and prices have responded accordingly. However, if rates normalize to higher levels, the portfolio volatility may be a price time bomb that could be set off with any movement toward higher yield.

Risks to Higher Rates
Unfortunately, there are a variety of events that could lead to higher rates and unpleasant portfolio surprises. The investment mantra “Don’t fight the Fed” is a reminder that at some point they are likely to make progress toward higher inflation and stronger economic growth, developments that both support higher rates. Recent wage increases, stable oil prices, and slower appreciation of the U.S. dollar can all contribute to higher inflation, as the Federal Reserve (Fed)  reverses its inflation-dampening effects of 2015. A U.S. fiscal stimulus package, driven by new leadership this fall, could also shift investor expectations of stronger growth and higher rates. Non-domestic effects also can influence U.S. rates. A reduction, for example, in the European Central Bank’s aggressive bond purchase program, currently scheduled to end in March 2017, would reduce demand for high-yielding U.S. debt. The elimination of such a major buyer of debt could allow rates in Europe to creep higher, allowing global investors to shift elsewhere some of their current U.S. debt purchases.

Time to Reassess Risk
While a significant turnaround in U.S. yield does not seem imminent, any development that starts the process could trigger a shift in investor attitudes, as safe investments become losing investments. Such a scenario may have driven Goldman Sachs to its conclusion in June that a 1% increase in the yield of U.S. Treasuries could cost investors as much as $1 trillion in losses. A 1% increase in U.S. Treasury yields is not our forecast; but it’s important to understand the level of interest rate risk in a portfolio if rates rise even slightly. Certainly, a well-diversified portfolio should include an allocation to high-quality bonds, but the current environment of low rates, and any maturity adjustments made to maintain yield, suggests a reevaluation of portfolio volatility could help avoid unwanted surprises if changes in the economy, inflation, fiscal policy, or monetary policy initiate a move to higher rates. 

 

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