econintersect.com
       
  

FREE NEWSLETTER: Econintersect sends a nightly newsletter highlighting news events of the day, and providing a summary of new articles posted on the website. Econintersect will not sell or pass your email address to others per our privacy policy. You can cancel this subscription at any time by selecting the unsubscribing link in the footer of each email.



posted on 21 September 2016

Potential Risks To Bonds, Part 2

by Gene D. Balas

In a recent piece, we discussed one angle to risks in the bond market. There are other ways to examine this as well, so this is Part II of that discussion.

ouija.board.380x200

To begin, longer term Treasury bond yields can be deconstructed into a few components.

  • The first component is the level of short term interest rates, not only now, but where they might be in the future.

  • Another component is the premium that investors demand over inflation.

  • And a third is the premium investors demand to hold longer term bonds, with their greater sensitivity to interest rate risk, should investors' interest rate forecasts not be accurate.

(Note: A bond's price moves inversely to its yield; and the longer the maturity of a bond, the more sensitive it is to interest rate movements. Corporate bonds and other instruments that have credit risk also have an additional yield premium; namely, the credit spread.)

Right now, Treasury bonds don't offer much in the way of compensation to investors for either inflation or interest rate risk. One might think that investors simply don't believe market-based expectations for the future rate of inflation, thinking that inflation won't, in fact, be that high. And investors may believe longer dated bonds are a better alternative to cash, with its near-zero returns, even if there is interest rate risk with holding longer dated bonds.

No inflation premium as foreign central banks push down yields globally

To illustrate these issues, consider the nearby graph that compares the 10-year U.S. Treasury yield with inflation expectations, using the five-year, five-year forward inflation rate from TIPS breakeven rates [1] along with the 10-year German bund yield. These data go back to 2003.

Look at two things:

  1. How Treasuries once offered a premium to inflation expectations - as is normally the case - before the recession (and even thereafter), and

  2. 10-year Treasuries now no longer offer any inflation premium currently, as they are dragged lower by low bonds in the Eurozone and elsewhere.

We'll use German longer term bund yields, which historically have exhibited a fairly tight correlation to 10-year Treasury yields, in this example. German bund yields have dropped due, in part, to the European Central Bank's bond-buying program.

10_Year_Treasury_Inflation_Expectations_German_Yields.png

In turn, low yields in Europe and Japan are causing foreign investors to buy (higher-yielding) Treasuries instead, pushing up prices and driving down yields. How do we know this? Consider that Joakim Tiberg, a strategist at UBS, told The Wall Street Journal that

"Japanese and Eurozone investors alone have absorbed the equivalent of nearly all U.S. Treasury net supply in the first quarter of 2016."

This highlights the effects the actions by Japan and Europe's central banks have on the U.S. Treasury market.

Needless to say, the bond market has become highly dependent on central banks, especially the ECB and the Bank of Japan, and the ECB recently hadn't discussed extending or expanding its QE program. The BOJ had a policy meeting this week, at exactly the same date as the Fed meeting.

A negative term premium: a lack of compensation for interest rate risk

Now on to the premium investors demand (or not) for accepting interest rate risk. Below is another graphical representation of another potential risk of Treasuries - the term premium on a 10-year zero coupon Treasury.

The term premium is the compensation that investors require for bearing the risk that interest rates do not evolve as they expected; when investors don't demand this extra compensation, it is may be an added source of risk. You'll see it is currently negative, which may indicate investors could be undertaking more risks should interest rates increase by more than what the market expects. (The calculation of the term premium is based on market expectations.)

Ten_Year_Term_Premum_Zero_Coupon_Treasury-1.png

So, not only do Treasuries not offer a premium to inflation, they also don't offer a premium to the deviations from the base-case expectation for the path of interest rates. The only other time the term premium has been negative in recent years has been during the Fed's bond buying program, especially in conjunction with the European sovereign debt crisis and the ECB's own QE program, all of which pushed Treasury yields lower. A negative term premium intuitively does not make sense, and economists debate reasons why it is negative in the current environment.

Conclusion

So, having discussed components of risk in Treasury bonds, can one accurately say whether Treasuries will, definitively, have a negative return, particularly after interest is taken into account? Here is where the big caveat comes in: in the famous adage, while markets may not always be rational, they can stay irrational longer than many investors can stay solvent. In other words, merely identifying risks does not guarantee the actual outcome, as there are too many variables that must be identified and interpreted, especially in the context of ever-present uncertainty. That is, after all, the nature of investing.

Disclosures

Investing involves risk, including possible loss of principal, and investors should carefully consider their own investment objectives and never rely on any single chart, graph or marketing piece to make decisions. The information contained in this piece is intended for information only, is not a recommendation to buy or sell any securities, and should not be considered investment advice. Please contact your financial adviser with questions about your specific needs and circumstances.

The information and opinions expressed herein are obtained from sources believed to be reliable, however their accuracy and completeness cannot be guaranteed. All data are driven from publicly available information and has not been independently verified by United Capital. Opinions expressed are current as of the date of this publication and are subject to change. Certain statements contained within are forward-looking statements including, but not limited to, predictions or indications of future events, trends, plans or objectives. Undue reliance should not be placed on such statements because, by their nature, they are subject to known and unknown risks and uncertainties.


© 2016 United Capital Financial Advisers, LLC. All Rights Reserved


[1] The TIPS breakeven is a metric of market-based inflation expectations that compares the yield of Treasury Inflation Protected Securities with the comparable non-inflation adjusted Treasury yield. The difference is the implied rate of inflation expected by the market. The five-year, five-year forward breakeven rate measures inflation expectations in the five years beginning five years from now.

>>>>> Scroll down to view and make comments <<<<<<

Click here for Historical Investing Post Listing










Make a Comment

Econintersect wants your comments, data and opinion on the articles posted.  As the internet is a "war zone" of trolls, hackers and spammers - Econintersect must balance its defences against ease of commenting.  We have joined with Livefyre to manage our comment streams.

To comment, using Livefyre just click the "Sign In" button at the top-left corner of the comment box below. You can create a commenting account using your favorite social network such as Twitter, Facebook, Google+, LinkedIn or Open ID - or open a Livefyre account using your email address.



You can also comment using Facebook directly using he comment block below.





Econintersect Investing


search_box

Print this page or create a PDF file of this page
Print Friendly and PDF


The growing use of ad blocking software is creating a shortfall in covering our fixed expenses. Please consider a donation to Econintersect to allow continuing output of quality and balanced financial and economic news and analysis.


Take a look at what is going on inside of Econintersect.com
Main Home
Analysis Blog
The Expected Effects of Petitions to Improve the Monetary System
Energy and Falling Productivity
News Blog
Infographic Of The Day: How The World's Most Iconic Logos Evolve Over Time
Early Headlines: Asia Stocks Down, Fed Wants Banks' Commodity Limits, Treasuries Being Sold, EZ Business Output Softens, France Contraction, Saudi's Boost Banks, Canada Tightens Borders For Chinese And More
Most Read Articles Last Week Ending 24 September
How Britain Owes Its Immigrants A Debt Of Gratitude
Super Mario, The Timeless Bestseller
Explainer: The Nine Swing States That Will Decide The Next US President
How Long Does Apple Support Older IPhone Models
What We Read Today 25 September 2016
Dangerous Ultra Pure Water
Job Employment Tenure Down
Mobile Payments Promise To Improve Financial Accessibility In Mexico
Aging Populations May Mean Lower Economic Growth
Urban Rebound Causes Large Shift In Lower Credit Borrowers To Seek The Outer Suburbs
Investing Blog
Monday Morning Call 26 September
We're Back Here We Started
Opinion Blog
Heading For A Fall? With Summer Over, Europe Must Face Up To Its Mounting Crises
What If We're In A Depression But Don't Know It?
Precious Metals Blog
War On Cash Turns To $20, $50, And $100 Bills
Live Markets
23Sep2016 Market Close: US Indexes Close Lower As Crude Prices Slip, Fed Lowers Economic Growth Prospects, Indicators Melting Into Bearish Territory
Amazon Books & More






.... and keep up with economic news using our dynamic economic newspapers with the largest international coverage on the internet
Asia / Pacific
Europe
Middle East / Africa
Americas
USA Government



Crowdfunding ....






























 navigate econintersect.com

Blogs

Analysis Blog
News Blog
Investing Blog
Opinion Blog
Precious Metals Blog
Markets Blog
Video of the Day
Weather

Newspapers

Asia / Pacific
Europe
Middle East / Africa
Americas
USA Government
     

RSS Feeds / Social Media

Combined Econintersect Feed
Google+
Facebook
Twitter
Digg

Free Newsletter

Marketplace - Books & More

Economic Forecast

Content Contribution

Contact

About

  Top Economics Site

Investing.com Contributor TalkMarkets Contributor Finance Blogs Free PageRank Checker Active Search Results Google+

This Web Page by Steven Hansen ---- Copyright 2010 - 2016 Econintersect LLC - all rights reserved