INSIGHTS

On July 18, 2016

AAM Viewpoints - Fixed Income Investments - Can History Repeat Itself?

The fixed income and equity markets, in my opinion, continue along peculiar paths. During a recent trading day, the equity market hit its then all-time high the same day the 10-year Treasury hit its all-time low yield. Although this be can rationalized away, it does not seem logical.

The current yield on the 10-year U.S. Treasury bond is at 1.55%.

The very friendly interest rate environment put in place by the various central banks should eventually accomplish the goal of stimulating the world economies and – in the opinion of some – might over stimulate creating inflation which could cause the same central banks to eventually raise interest rates. If this occurs, we believe we will likely shift from a 30-year bull market to possibly a bear market in fixed income markets.

Seeing how the bull market in bonds is over 30 years old, understandably there are many investors who only have experienced this bull market in bonds.

Looking back at historical levels, on the close of business 7/8/2016, the 10-year Treasury bond yield hit an all-time low at 1.358%. The highest yield recorded on the 10-year Treasury was a 15.84% at close of business (COB) 9/30/1981. If interest rates back up halfway between the low and high, that yield between the high and low is 8.60%. The 8.60% yield would make the dollar price on the current 10-year Treasury a $54.35. Admittedly that is so 1980s. Let’s move to the 21st century. The highest yield on the 10-year Treasury in the 2000s was a 6.78% on COB 1/20/2000, which makes the simple average between the high of 6.78% on 1/20/2000 and the low of 1.358% on 7/8/2016 a 4.07% yield. At a 4.07% yield, the value of the current 10-year Treasury would be approximately $80.36. That is a drop just under 20%. It is generally accepted that a 20% drop in the equity market constitutes a bear market; close enough for me.

Is it out of the realm of possibilities that with all the economic stimulation across the globe that at some point we will not see a 4.00% yield on the 10-year Treasury? To me the only question is when.

When considering the large movement in price referenced above, it’s also important to evaluate the duration of a bond. There are a couple definitions for duration. Duration measures the sensitivity of a bond’s price to a change in interest rates. Duration approximates the percentage change in price for a 100 bps (basis points) movement in interest rates. If a bond has a duration of nine years, then a 1% (or 100 bps) increase in interest rates reduces the market value of the bond by 9%. The duration on the 10-year U.S. Treasury is about nine years. The lower the duration the less impact on the market value of the bond when interest rate move and the higher the duration, the greater the impact interest rate moves have on the market value of the bond.

Managing duration is especially key if you are wary of higher interest rates. Bond features impact duration. Maturity is one component that impacts duration; the longer the maturity the higher the duration. Another component is the size of the coupon. The larger the coupon, the lower the duration. Call features on premium bonds can lower the duration; these bonds are known as cushion bonds and although this has the potential to be an effective strategy, a good understanding of cushion bonds is recommended.

If you think history can repeat itself, structuring a portion of your fixed income investments more defensively may be worth considering. Making your own decisions with the help of your advisor or having your fixed income investments professionally managed in separately managed accounts are options. Your financial advisor can be assistance in helping you make these decisions.

CRN: 2016-0705-5448 R

This commentary is for informational purposes only. All investments are subject to risk and past performance is no guarantee of future results. Please see the Disclosures webpage for additional risk information. For additional commentary or financial resources, please visit www.aamlive.com.