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Fixed-Income Insights

The factors that fueled the decline in Treasury yields will soon be history. What can investors expect should Treasury supply—and yields—start to rise significantly?

 

In Brief

  • Treasury yields have fallen in 2014 amid a declining supply of Treasury issues on the market and rising investor demand for government securities.
  • Meanwhile, yield spreads versus Treasuries for investment-grade corporate debt and high-yield securities have narrowed, as investors continue to seek compelling alternatives to low-yielding government securities.
  • But the supply-demand dynamic that dominated the first six months of the year seems unlikely to follow the same trajectory over the balance of the year, with Treasury supply likely to increase due to various factors.
  • The key takeaway—Should Treasury yields climb—and prices fall—over the coming months, investors may wish to consider other fixed-income alternatives that may provide better relative returns, such as high-yield corporate bonds.

 

As we discussed in a recent post on the Lord Abbett blog, the supply of U.S. Treasury securities has been plummeting in 2014 at the same time that investor demand has increased. According to the Securities Industry and Financial Markets Association (SIFMA), the Treasury offered net new issuance of about $201 billion through June 2014, compared with about $338 billion in the year-ago period. Even though the Federal Reserve (the Fed) actively reduced its purchases of longer-dated U.S. Treasury securities beginning in January 2014, it bought $190 billion, or nearly 95% of the Treasury’s issuance during the first six months of the year. This compares with the Fed’s purchases in 2013, when it purchased $270 billion, or about 80% of net new issuance, leaving more than $68 billion for other potential buyers.

Supply contracted faster in 2014 than the Fed was able to taper its purchases, owing largely to a shrinking U.S. budget deficit, which reduced the government’s borrowing needs. This supply-demand dynamic suggests yields may have declined in the first half of 2014 even without the additional Treasury demand from rising geopolitical concerns, slower than expected U.S. gross domestic product growth, and the attractive yields on Treasuries relative to government debt of other developed countries. 

But the supply shift extends beyond Treasuries. According to SIFMA, issuance of mortgage-related securities fell by more than 52% in the first six months of 2014, versus the same period in 2013. Through June, issuance was only $547 billion, compared with $1,142 billion for the year-ago period. Issuance of agency securities also fell noticeably. For the first half of 2014, issuance was $84.1 billion, compared with $224.8 billion a year earlier, a 34% drop. Corporate bond issuance bucked the trend with a slight increase. For the first six months of 2014, issuance of corporate debt increased, to $785 billion, compared with $729 billion one year earlier. Corporate debt aside, the surprise to investors may not be that yields fell during this period, but that they didn’t fall further. 

Narrower Spreads for Credit Risk
During this period, as yields on Treasuries and other high-quality securities declined, and these issues, consequently, became less attractive, bond investors appeared to look for alternatives among other debt categories, including higher-yielding corporate bonds. Indeed, the market for corporate bonds improved steadily throughout this six-month period.  As a result, spreads narrowed between investment-grade debt and comparable Treasuries, as well as between high-yield debt and comparable Treasuries. (See charts 1 and 2.) Thus, even though supply fell more precipitously among Treasuries, agencies, and mortgage-related securities, corporate bonds were the beneficiaries.

 


Chart 1. Yield Spreads Have Narrowed between Investment-Grade Debt and Treasuries

Yield spread over representative Treasury index, June 1994-June 2014

Source:Barclays.
*Represented by Barclays U.S. Corporate Baa-Rated Bond Index.
**Represented by Barclays  U.S. Corporate A-Rated Bond Index. 
Past performance is no guarantee of future results.
For illustrative purposes only and does not represent any specific Lord Abbett mutual fund or any particular investment.
Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment. Bonds may also be subject to other types of risk, such as call, credit, liquidity, interest-rate, and general market risks. Longer-term debt securities are usually more sensitive to interest-rate changes; the longer the maturity of a security, the greater the effect a change in interest rates is likely to have on its price. Lower-rated bonds may be subject to greater risk than higher-rated bonds
.


Chart 2. Yield Spreads Have Narrowed between High-Yield Debt and Treasuries
Yield spread over representative Treasury index, June 1988–June 2014

Source: Credit Suisse. Yield spreads represented by the Credit Suisse High Yield Index.
Past performance is no guarantee of future results.
It is important to note that the high-yield market may not perform in a similar manner under similar conditions in the future. The historical data shown in the chart above are for illustrative purposes only and do not represent any specific Lord Abbett mutual fund or any particular investment.
Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment. High-yield securities carry increased risks of price volatility, illiquidity, and the possibility of default in the timely payment of interest and principal.

 

A Changing Landscape
The supply-demand dynamic that dominated the first six months of the year seems unlikely to follow the same path over the balance of the year. The Fed’s course to eliminate all bond purchases by October (which it confirmed on July 9 with the release of minutes from its policy meeting on June 17–18) will require other investors to absorb that supply. 

At the same time, Treasury supply is likely to increase. The seasonality of tax flows suggests that those tax revenues that reduced the need for Treasury financing in the spring will be less forthcoming over the balance of the year. Monthly financing requirements over the balance of 2014 are likely to be higher than they were during the first five months of the year. Deutsche Bank expects monthly Treasury issuance to increase to about three times the January to May pace, based on Congressional Budget Office (CBO) estimates. Even at half that pace, without any purchases by the Fed, yields seem destined to rise, consistent with the Fed’s longer-term objective of a return to normal monetary policy.

Beyond 2014, it is unlikely that we will see another decline in Treasury supply similar to that which occurred during the first part of the year. Although 2015 likely will see a further decline in the budget deficit, it will be much smaller than the decrease seen in 2014. After 2015, the CBO projects budget deficits will begin a long trend of rising. These changes in the federal budget suggest higher levels of issuance of Treasuries. Further, the Fed’s quantitative-easing program is ending, removing a major buyer from the market. 

All told, the Treasury supply-demand shift of early 2014 seems likely to head in the opposite direction. An improvement in U.S. economic growth (consistent with the International Monetary Fund’s U.S. gross domestic product forecast of 3% for 2015) will support the Fed’s desire for a gradual rise in interest rates starting next year, ushering in a period of more normal monetary policy.   

An increase in Treasury rates, however, does not necessarily signal similar moves in other fixed-income categories. Over the past 20 years, for example, there have been seven instances when the yield on the 10-year Treasury note has moved higher by at least 100 basis points (bps) within a 16-month period. In each one of these periods when the 10-year Treasury return has been negative, there have been other fixed-income asset classes in which return has been positive, including bank loans, shorter-term corporates, high-yield securities, and convertible bonds. If a stronger U.S. economy gives the Fed latitude to begin raising rates in mid-2015, bonds with greater interest-rate sensitivity may continue to perform relatively well. High-yield debt is a good example. Apart from its traditional role as a vehicle for investors seeking a higher income stream, this asset class historically tends to outperformother categories in terms of total return when Treasury rates rise meaningfully.

In each of the seven intervals in which the 10-year Treasury yield rose meaningfully, the spread between high yield and underlying U.S. Treasuries compressed. Chart 3 illustrates this phenomenon. In each case of rising interest rates, historically, high-yield securities provided higher income and, as is implied by the narrowing in spread, provided attractive relative price return as well. [Due to market volatility, the market may not perform in a similar manner in the future.]

 

Chart 3. High-Yield Spreads versus Treasuries Historically Have Compressed as Interest Rates Have Risen
Yield spread over representative Treasury index, June 1988-June 2014

Source: Credit Suisse. Yield spreads represented by the Credit Suisse High Yield Index. Shaded areas represent intervals when the yield on the 10-year Treasury note has moved higher by at least 100 basis points (bps) within a 16-month period.
Past performance is no guarantee of future results.
It is important to note that the high-yield market may not performing a similar manner under similar conditions in the future. The historical data shown in the chart above are for illustrative purposes only and do not represent any specific Lord Abbett mutual fund or any particular investment.
Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment. High-yield securities carry increased risks of price volatility, illiquidity, and the possibility of default in the timely payment of interest and principal.

 

Investment Implications
If Treasury yields climb and prices fall because the supply-demand dynamics that favored lower Treasury yields change, or because geopolitical risk calms, or monetary policy heads toward normal, there are other fixed-income alternatives that potentially may provide better relative returns. In past rising-rate environments, fixed-income asset classes such as bank loans, shorter-duration corporates, high-yield securities, and convertibles have provided more attractive returns than their U.S. Treasury counterparts. [However, there is no guarantee that the fixed-income market will perform in a similar manner under similar conditions in the future.]

 

ABOUT THE AUTHOR

RELATED FUND
The Fund seeks to deliver current income and the opportunity for capital appreciation by investing primarily in U.S. investment grade corporate, government, and mortgage- and asset-backed securities, with select allocations to high yield and emerging market debt securities.

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