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posted on 15 December 2016

Are Bonds Now Priced Right - Or Do Risks Remain?

by Gene D. Balas

In two recent blog posts, we discussed risks to the bond market (here and here). We also discussed whether inflation may emerge - or even surge - in another blog post. Now that some of those risks have come to fruition, with the yield of the 10-year U.S. Treasury jumping to about 2.4% from roughly 1.4% in July - sending prices down - the question is, do risks still remain, even after this rout in the bond market?

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And our answer to that question is yes, there are further risks in the bond market. No one can consistently forecast the exact direction and levels of interest rates in the future, but one can identify different types of risks one may likely undertake. With that in mind, let’s look at a few variables in the bond market and what they tell us about the compensation investors may (or may not) receive from undertaking these risks.

Yield components and sources of risk and compensation

To begin, yields consist of a few basic ingredients including:

  • the levels and direction of short term interest rates, such as set by the Federal Reserve,

  • the term premium, or what you would get by investing in a single longer term bond instead of reinvesting a series of short term instruments,

  • an inflation premium, or the yield above the expected inflation rate, and

  • the credit spread for any security not backed by the full faith and credit of countries such as the U.S., Germany and Japan.

These represent compensation for different types of risk: interest rate risk, in the case of the term premium; inflation risk, in the case of the inflation premium; and credit risk, in the case of the credit spread. The greater these are, the better compensated an investor is for undertaking these risks. If these levels are low, well then, the investor isn’t being paid as much to take on that risk.

What does the term premium tell us?

First, we see that the term premium of a 10-year Treasury bond is negative. That means that it might be better to hold assets in cash and earn what is expected to be a higher return investing in a series of short term instruments than in a single investment in the longer maturity 10-year bond. The term premium is the difference in yield of the longer term bond versus the expected returns of investing in a series of shorter term instruments. This is not surprising given that Fed officials expect the short term Fed funds rate in the longer term to eventually be in the range of 2.5% to 3.8% (when submitting their individual views, hence the range), making the 10-year yield of 2.4% less attractive than what may be higher rates on cash in the future.

Usually, the term premium is positive, as is seen in the nearby graph, as it is the compensation investors receive for undertaking the interest rate risk of investing in a longer maturity bond. In this case, we might not be compensated for that risk.

IM_1.png

What does the inflation premium indicate?

Then there is the inflation premium, which is currently about zero. Usually it is positive by a notable amount, as seen in the nearby chart. The data series in this is the 10-year Treasury yield minus the expected rate of inflation in the five years beginning five years from now, known in finance parlance as the five-year, five-year forward breakeven. (It is calculated from the values of the yield on Treasury Inflation Protected Securities (TIPS) and the yield on conventional Treasury securities.) An increase in inflation expectations can cause the price of bonds to fall, especially if there is not enough of a “cushion" in the inflation premium already priced in.

IM_2.png

What about credit spreads?

Corporate bonds rated AA are often a benchmark for U.S. investment grade corporate bonds. The difference in the yield of these bonds above that of Treasuries is the compensation investors receive from credit, or default, risk. Known technically as the AA option-adjusted spread, this form of compensation is in line with its longer-term tendencies (outside of recessions), and is not especially generous. During recessions, this spread can spike, and like any other form of an increase in interest rates, it can sometimes lead to price losses, unless the yield of the comparable risk-free bond falls more than this spread rises.

IM_3.png

Economic policy uncertainty is high

Regardless of one’s political views, the market has its own assessment of economic policy uncertainty. When uncertainty is high, credit spreads tend to increase, and when uncertainty lessens, spreads tend to decrease. This relationship can be seen in the nearby chart, especially important as the new administration is clarifying its economic policies, plans and programs for the coming term. To the extent the new administration can ease uncertainty, it may have a calming action on the market - but the converse is true as well.

IM_4.png

Thus, with a negative term premium, no inflation premium, and credit spreads that aren't all that generous - especially factoring in economic policy uncertainty - one may still be a bit cautious in fixed income. Of course, no forecast ever pans out correctly, so we are not attempting to determine the direction of interest rates. But whatever the direction of rates, are investors being compensated for the risks they undertake? These data suggest otherwise.


Disclosure

In general the bond market is volatile, and fixed income securities carry interest rate, market, inflation, credit and default risk. Any fixed income security sold or redeemed prior to maturity may be subject to a substantial gain or loss. 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. Indices are unmanaged, do not consider the effect of transaction costs or fees, do not represent an actual account and cannot be invested to directly. International investing entails special risk considerations, including currency fluctuations, lower liquidity, economic and political risks, and different accounting methodologies.

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