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April 15, 2024
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Financial Industry Insights from Advisors Asset Management
On August 15, 2016
AAM Viewpoints - The Risky Nature of the “World’s Safest Bond Market”
U.S. Treasuries are the safest, most liquid fixed income investment in the world and the market serves as the risk-less benchmark for a whole host of other financial instruments around the globe. The idea of U.S. Treasuries as a risk-less investment belies the true nature of what could be one of the riskier U.S. bond markets for investors seeking income and safety of principal. The safety of Treasuries reflects the fact that there is little to no credit risk. In other words, the United States is one of the most creditworthy issuers in the world. While they may be looked at as risk-less from the standpoint of credit risk, they are subject to principal fluctuation due to interest rate movements. The 10-Year Treasury touched a historical low of 1.36% in early July (07/08/2016) and the average duration of the U.S. Treasury market is at one of the highest levels in history1 (6.7 years). With the market-weighted average coupon sitting at 2.45%1 the U.S. Treasury market looks to be one of the riskier markets in the world from an interest rate standpoint. Moving forward, investors seeking income and preservation of capital should consider whether the risk to principal warrants the modest income provided via an investment in U.S. Treasuries.2
There are a multitude of rationales for the tenacity of the low rate environment in the United States post credit crisis, not the least of which has been the FOMC’s (Federal Open Market Committee) zero-rate accommodation. While U.S. monetary policy has certainly contributed in large part to how we got here, rates have actually fallen to lower levels since the Federal Reserve began to tighten policy in December 2015. Outside of FOMC policy, explanations for the persistence of low interest rates generally include structural factors such as demographics and savings rates, sub-par growth expectations and foreign demand.3 These three factors have most likely helped to support low yields in the U.S. Treasury market but even with these factors there are reasons to believe that rates could move higher.
First, in regards to structural factors, it is no secret that the U.S. population is aging with a larger cohort of the population at or nearing retirement. The personal savings rate in the United States has also climbed steadily since 2008. Both of these factors point to larger bond allocations in investment portfolios on average and a greater need for income and safety. With that being said savers and retirees concerned with principal preservation need a rate of return that exceeds inflation to maintain purchasing power. The 10-Year Treasury is currently at 1.51% (8/10/2016) and an erosion of purchasing power with even modest levels of inflation is a real possibility. Demand from savers and retirees seems to better support the strong appetite for corporate bonds rather than demand for Treasury holdings. Expectations for future growth also plays a role in driving yields in the U.S. Treasury market. Over longer timeframes, yields in the Treasury market should approximate the growth rate of the U.S. economy, but even the current weak GDP (Gross Domestic Product) and inflation numbers would seem to support slightly higher rates.3 Foreign demand is also putting pressure on interest rates in the United States. Where the United States has started to tighten monetary policy, the balance of developed markets are still extremely accommodative. This has pushed down yields across the world sending global bonds into negative yield territory. This makes U.S. interest rates look appealing and is driving stronger demand for U.S. Treasuries by foreign investors.4 Until central banks around the world begin to dial back accommodative monetary policy one would expect developed market yields to stay depressed. However, recent developments point to the potential for weaker foreign demand in the United States moving forward. When a foreign investor invests in U.S. Treasuries they must convert their local currency into U.S. dollars – exposing the investment to currency risk. For the last several years the yield differential between U.S. and foreign sovereign debt has been wide enough that foreign investors could not only earn a healthy yield spread in the United States, they could do so and hedge the risk of currency fluctuations. As foreign demand has increased, the costs of hedging currency risk has also increased and hedged U.S. yields for foreign investors are now zero to negative.5 Without the ability to hedge away currency risk and earn a positive return, investment in U.S. Treasuries for foreign investors becomes a more risky proposition. This could result in easing foreign demand and take some pressure off U.S. yields.
If interest rates in the United States were to begin to normalize and move up even 50 bps (basis points) to 100 bps then the risks to principal invested in the U.S. Treasury market would increase markedly while income levels would struggle to match inflation. With bond yields near all-time lows and bond prices near all-time highs we feel the current environment provides an opportunity to defensively position portfolios in regards to interest rate risk. This begins with an analysis of portfolio duration which is a key measure of interest rate sensitivity. For every year of duration investors should expect to lose approximately 1% in principal for every 100 bps movement up in rates. Portfolio duration should be positioned based upon investor risk tolerance and a lower tolerance for principle volatility should be paired with a lower portfolio duration. In addition to a defensive duration, where risk tolerance allows, we would consider lightening up allocations to U.S. Treasuries. If credit quality is paramount one could consider TIPS (Treasury Inflation Protected Securities) as an alternative. Not only could TIPS help to protect purchasing power, higher rates are strongly correlated with higher inflation which could potentially help TIPS outperform traditional Treasury holdings in a rising rate environment. Finally, investors who are comfortable with adding credit risk might consider increasing allocations to high quality corporates and/or taxable municipal bonds. These investments are more sensitive to the credit cycle and less sensitive to interest rates than comparable Treasury bonds. As always, investor objective and risk tolerance should drive all allocation decisions and moving away from U.S. Treasury allocations might not be appropriate for all investors.
CRN: 2016-0808-5500 R
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