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Market View

Investors who are buying a 10-year Treasury bond we believe are essentially locking in a net-of-inflation return of zero over the next decade. 

With the market expecting multiple fed fund rate cuts, and some analysts predicting a recession, many investors are wondering if they should add duration to their fixed-income portfolios.

We see three problems with adding duration at this point in time:

First, markets have already priced in those rate cuts. Yields and valuations today (as of July 19, 2019) reflect the expectation of almost four rate cuts by the U.S. Federal Reserve (Fed) over the next 12 months, a dramatic reversal from prior expectations of Fed rate hikes. Fed actions in line with those expectations would be unlikely to move rates further.

Importantly, longer term rates are not directly affected by Fed actions, as the Fed only controls the overnight rate at which banks lend excess reserves to one another. Historically, Fed cuts have actually resulted in rising 10-year rates, as accommodative monetary policy can cause the market to reassess  growth and inflation expectations. As we can see in Chart 1, the last four times the Fed cut, 10 year Treasury yields fell in anticipation of Fed moves, only to rise once the Fed had started a cycle of cuts.

 

Table 1.  Historically, Rate Cuts Have Been Anticipated and Priced into the Market
10-year U.S. Treasury bond yields over selected periods

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.

 

Second, there is very little upside left for investors who are looking to add duration in order to defend against a possible recession. Historically, 10-year U.S. Treasury bond yields have been much higher, usually above 6%, before a recession, allowing for double digit returns from fixed income investments when yields fell in anticipation of economic weakness. With yields already at 2%, there is very little room for yields to go much lower, and very little income to cushion a rate rise.

Third, investors are simply not being compensated for moving farther out on the yield curve. As we have discussed, longer term yields are less directly sensitive to Fed activity than shorter term yields, and can be impacted by a wide range of factors. Importantly, with pension funds and central banks adding trillions of dollars’ worth of longer duration assets for reasons that have little to do with risk/return considerations, returns typically associated with taking longer-term risk have been squeezed out of the market, observable via the lack of yield differential between short term and long term yields. This “flattening” of the yield curve over the past five years has left bond investors with a term premium (incremental compensation for longer term investments) that is actually negative, as calculated by the New York Fed.

Not only are investors not adequately compensated for tying up their money for longer periods of time, but they are barely compensated for low levels of expected inflation. Real interest rates – Treasury rates minus inflation – are hovering near zero. Investors who are buying a 10-year Treasury bond are essentially locking in a net-of-inflation return of zero over the next decade.  Should inflation actually rise above today’s low expectations, those “real” returns would be negative. Adding duration by investing in longer duration assets does little for a portfolio beyond adding volatility, given current valuations.

 

Chart 1. Given Low Real Yields and a Negative Term Premium, U.S. Treasury Bonds are Riskier Than Usual
Real U.S. 10-Year Treasury bond yield and estimated term premium (1964-2019)

Source: Federal Reserve Bank of New York and Bloomberg.  Data as of June 30, 2019.  Term premium as represented by the 10-year tem premium.  Real 10-year yield as represented the 10-year U.S. Treasury bond yield less the Consumer Price Index (year-over-year). 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.

 

Summing Up

  • Adding duration at current rate levels is unlikely to give investors easy gains, protection, or an attractive risk/return profile.
  • While the market widely expects that the Fed will cut the Fed Funds overnight rate on July 31, that move has been amply telegraphed, and is already fully reflected in all interest rate markets.
  • Investors who tried to add interest rate risk prior to other Fed cutting cycles often lost money, and with the market currently pricing four cuts over the next twelve months, it would seem there is room for the Fed to undershoot expectations.
  • Moreover, with rates already so low, there is very little opportunity for material price appreciation, and also very little cushion for investors to earn their way out of an adverse rate move.

It can be tempting for investors to try to anticipate price movements in fixed income markets, given the extraordinary attention given to actions by the Fed. However, investors should recall that widespread attention means something is hardly a secret, and likely to be fully priced in to today’s valuations.  Instead of trying to anticipate price movements, investors may be better served by focusing on the income part of their fixed income investments, and letting their own sense of reasonable income (or lack thereof) guide their decisions.

 

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.

Glossary of Terms

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

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. 

Term premium is the incremental compensation investors receive for risks associated with a longer-term bond.

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 yield on a bond is the return an investor receives on a bond.

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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