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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.

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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.

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