When “Risk Free” Means “Yield Free” | Lord Abbett
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Fixed-Income Insights

Ultra-low or negative rates on global government bonds present challenges for income-seeking investors. Here are some options they may wish to consider.

Read time: 4 minutes

 

In Brief

  • Globally, government bonds now provide little or no yield; indeed, about one-third of developed market government bonds provide negative yields.
  • The United States, long seen as a relative haven for income investors, now has interest rates at or near 0%.
  • We believe investors seeking income may wish to consider diversified credit as a means to generate yield.

 

Government bonds provide the foundation and reference point for decision-making and analysis for investing and are a core constituent of both institutional and high net worth asset owners’ portfolios. Indeed, the 60/40 apportionment of equities and bonds has been a traditional baseline allocation for decades.  As an asset class, government bonds historically have been valuable sources of stability in portfolios, important hedging instruments, a financial basis for liability matching by insurers and pension funds, and of course, low-risk sources of income for a wide range of investors.

The fiscal response to the 2008–09 global financial crisis by central banks around the world served as the catalyst for a steady erosion of government bond yields across developed markets. Today, certain central banks like the European Central Bank, Bank of Japan, and others not only have overnight policy rates below 0% (Figure 1) but the effective yields on longer term government bonds are also negative as well (Figure 2). 

 

Figure 1. Selected Major Central Bank Overnight Rates, 2012–2020 (through July 31)



 

Figure 2. Selected Government Bond Yields by Tenor as of July 31, 2020

Source for Figures 1 & 2: Bloomberg. Data as of July 31, 2020. Data reflect country- or region-specific central bank benchmark rate indexes (Figure 1) and maturity-specific government bond indexes (Figure 2) maintained by Bloomberg.

Past performance is not a reliable indicator or guarantee of future results. For illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment. 

 

For income investors, these are difficult times indeed.  Given this backdrop, it is worth reviewing what the overall composition of the yield opportunity is in developed market government bonds.  Across developed markets and including all tenors, the average government bond yield was approximately 0.2% as at July 31, 2020.  While the long-term trend in nominal government bond yields has been, in general, characterized by decline, Figure 3 shows that from late 2015 to the end of 2018, the average government bond yield rose.  This coincided with a period of reasonably strong and sustained expansion in the United States; under these conditions, the U.S. Federal Reserve (Fed) took the opportunity to raise interest rates nine times over the three-year period and in part, replenished some of its fiscal policy toolkit.

 

Figure 3. ICE BofA Global Government Index Yield to Maturity, 2000–2020 (through July 31)

Source: ICE BofA Global Government Index via Bloomberg. Data as of July 31, 2020.

Past performance is not a reliable indicator or guarantee of future results. For illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment. 

 

And while the yields on U.S. government bonds had largely been one of the most attractive amongst their developed market peers (and hence until recently the source of high hedging costs) the rapid and forceful intervention in interest rates from the Fed to bolster the U.S. economy in reaction to the impact of the COVID pandemic has led the yields of U.S. Treasuries to their lowest levels in history.  While Fed chair Jay Powell has disavowed an interest in following other central banks in pursuing a negative rates policy, the Fed has guided towards a zero bound in its interest rate policy; as at July 31, 2020, the U.S. Fed Funds rate upper bound sits at 0.25%.  Nearly 60% of the ICE BofA All Maturity U.S. Government Index provides yields less than 0.25% and yields on the U.S. 10-year Treasury now sit at 0.53%, which, according to Deutsche Bank, is a 234-year low.[1]

Now as U.S. Treasuries are at their lowest-ever yields, and with a relatively flat yield curve at that, reflecting low forward inflation expectations, the yield opportunity in U.S. government debt has largely evaporated. Figure 4 depicts the impact this trend has had on global government bond yields in greater detail.  Yields on many government bonds have been negative for several years. German 10-year bonds have had negative yields since the end of Q1 2019. Today just over a third of global government bonds provide a negative yield and just under half of one percent have a yield greater than 1%.

 

Figure 4. Distribution of Global Government Bond Yields, 2000–2020 (through July 31)

Source: ICE BofA Global Government Index via Bloomberg. Data as of July 31, 2020.

Past performance is not a reliable indicator or guarantee of future results. For illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment. 

 

The days of government bonds yielding 4% or higher appear to be long behind us, and even a relatively lofty figure of 3% has disappeared for the time being.  In order to achieve yields of greater than 1% today, investors must assume significant duration risk and must consider bonds with effective durations of nearly 20 years or even higher.  And while inflation does not seem as though it is an imminent concern at present given the challenging macroeconomic conditions globally, the risk-reward of very long dated government debt does not appear especially attractive, in our opinion.

 

Figure 5. Effective Duration of Global Government Bond Yields by Yield to Worst, July 31, 2020

Source: ICE BofA Global Government Index via Bloomberg. Data as of July 31, 2020.

Past performance is not a reliable indicator or guarantee of future results. For illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment. 

 

So with income becoming increasingly unavailable from government bonds, how should investors think about adding yield to their portfolios?  Despite the retracement in spreads post central bank and government interventions in response to COVID-19, credit – both investment grade and high yield –offered yields at the time of writing that we believe are attractive to their risk-free reference points.  In the current environment, BBB-rated corporate credit, higher quality below-investment grade credit and selected higher quality tranches of securitized asset classes all offer income that could satisfy a requirement once met by government bonds, with varying levels of principal risk.  And while yields on corporate bonds and other income-generating assets are lower than they have been historically, the various monetary and fiscal programs introduced by major central banks around the world in response to the pandemic have been effective in providing a much-needed reinforcement to the global financial system. These actions have stabilized and materially improved market liquidity and overall functioning, by enhancing the flow of credit to both corporate issuers and consumers alike and materially underpinning demand for risk assets.  Further, investors historically have been well-compensated for the risks they underwrite in credit. As investors consider where to invest cash that has been on the sidelines during this recent period of volatility or seek to reinvest maturing government debt they currently hold, the opportunities for positive-yielding credit remain attractive, in our opinion.

Credit risk can be diversified both within corporate sectors and among fixed income sectors.  To accomplish this and garner yield from the most attractive segments of the credit markets as they change on a relative basis, we believe investors should be considering a well-resourced multi sector approach from an experienced manager to complement traditional government bond allocations.

 

[1] “Chart of the Day,” Deutsche Bank, July 31, 2020.

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. High-yield securities, sometimes called junk bonds, carry increased risks of price volatility, illiquidity, and the possibility of default in the timely payment of interest and principal. 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. No investing strategy can overcome all market volatility or guarantee future results.

Diversification does not protect against the risk of principal loss in a declining market.

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.

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.

 

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.

Glossary of Terms

A basis point is one one-hundredth of a percentage point.

Duration is a measure of the sensitivity of the price (the value of principal) of a fixed-income investment to a change in interest rates.

The risk-free rate of return is the theoretical rate of return of an investment with zero risk. The risk-free rate represents the interest an investor would expect from an absolutely risk-free investment over a specified period of time.

Securitized assets are created through a procedure called securitization, where an issuer designs a marketable financial instrument by merging or pooling various financial assets into one group. The issuer then sells this group of repackaged assets to investors.

Spread is the percentage difference in current yields of various classes of fixed-income securities versus Treasury bonds or another benchmark bond measure. A bond spread is often expressed as a difference in percentage points or basis points (which equal one-one hundredth of a percentage point). The option-adjusted spread (OAS) is the measurement of the spread of a fixed-income security rate and the risk-free rate of return, which is adjusted to take into account an embedded option. Typically, an analyst uses the Treasury securities yield for the risk-free rate.

Tenor refers to the length of time until a financial obligation such as a loan or bond is due.

Bloomberg Barclays Index Information (see Figures 1 & 2):

Source: Bloomberg Index Services Limited. BLOOMBERG® is a trademark and service mark of Bloomberg Finance L.P. and its affiliates (collectively “Bloomberg”). BARCLAYS® is a trademark and service mark of Barclays Bank Plc (collectively with its affiliates, “Barclays”), used under license. Bloomberg or Bloomberg’s licensors, including Barclays, own all proprietary rights in the Bloomberg Barclays Indices. Neither Bloomberg nor Barclays approves or endorses this material, or guarantees the accuracy or completeness of any information herein, or makes any warranty, express or implied, as to the results to be obtained therefrom and, to the maximum extent allowed by law, neither shall have any liability or responsibility for injury or damages arising in connection therewith.

The ICE BofA All Maturity U.S. Government Index tracks the performance of U.S. public debt through all available maturities.

The ICE BofA Global Government Index tracks the performance of public debt of investment-grade sovereign issuers, issued and denominated in their own domestic market and currency. It is a market value-weighted measure of these bonds.

ICE BofA Index Information:

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, OR ANY OF ITS PRODUCTS OR SERVICES.

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 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 principle on these securities.

The information provided is not directed at any investor or category of investors and is provided solely as general information about Lord Abbett’s products and services and to otherwise provide general investment education.  None of the information provided should be regarded as a suggestion to engage in or refrain from any investment-related course of action as neither Lord Abbett nor its affiliates are undertaking to provide impartial investment advice, act as an impartial adviser, or give advice in a fiduciary capacity. If you are an individual retirement investor, contact your financial advisor or other fiduciary about whether any given investment idea, strategy, product or service may be appropriate for your circumstances.

The opinions in this article are as of the date of publication, are subject to change based on subsequent developments, and may not reflect the views of the firm as a whole. The material is not intended to be relied upon as a forecast, research, or investment advice, is not a recommendation or offer to buy or sell any securities or to adopt any investment strategy, and is not intended to predict or depict the performance of any investment. Readers should not assume that investments in companies, securities, sectors, and/or markets described were or will be profitable. Investing involves risk, including possible loss of principal. This document is prepared based on the information Lord Abbett deems reliable; however, Lord Abbett does not warrant the accuracy and completeness of the information. Investors should consult with a financial advisor prior to making an investment decision.

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