How Low Can They Go?
Near-Zero Interest Rates Pose Challenges for Bond Investors
By Mark Newlin, managing director – Fixed Income Management
It’s no secret that interest rates are low. How low are they? Interest rates on United States Treasury securities are currently so low that to get yield that matches the current inflation rate you'd need a bond with at least 17 years to maturity. In other words, unless inflation declines, buying and holding a 10-year Treasury note may actually result in a negative real rate of return over the over the next 10 years – and that's before taxes!
More Downward Pressure
Most analysts agree that today's low interest rates are due, in large part, to the Great Recession. That economic decline, and the subsequent lackluster recovery, reduced the demand (and thus the price) for borrowed funds. More recently, money flowing into U.S. Treasuries from distressed economies and currency regimes, like Europe, has pushed prices up and yields down even further.
And rates may remain low for the next few years, for several reasons. Most obviously, the Federal Reserve has signaled its intention to keep short-term rates near zero through 2014 – and possibly beyond. Second, despite years of increased rates of foreclosure and bankruptcy filings, our society is still over-leveraged by most measures. Debt liquidation has a strong dampening effect on the economy and interest rates. Unemployment is still high and capacity utilization is low. This "slack" in the economy makes raising prices difficult and may keep inflation low. Finally, an increasing ratio of retirees to workers will continue downward pressure on interest rates for a long time to come.
Nowhere to Go But Up?
Yet with two-year Treasury rates hovering at a mere 0.25% and 10-year rates at only 1.70%, it seems they couldn't possibly decline any further. Perhaps there's nowhere to go from here but up. Any long-term effects on inflation from the Fed's unprecedented and unconventional monetary policies have yet to be felt. And as investors begin to redeploy monies sheltered during the recent "flight to quality," we believe that Treasury rates should get a boost – at least to the point where they provide a positive real rate of return.
While past performance is no guarantee of future results, we often look for market patterns that can help us understand what may happen in the future. The below chart shows a striking correlation between the yield of the U.S. taxable bond market, as represented by the Barclay's Aggregate Bond Index, and the market’s total return over the subsequent five years. Unfortunately, by this measure, investors can expect annual bond returns of only about 1.6% over the next five years.
Source: Barclays Capital
The math behind that conclusion may seem counterintuitive. Although interest makes up the majority of long-term returns for bonds, when interest rates go up, bond prices come down. That price decline eats into total returns. But bonds also pay monthly or semiannual coupons that must be reinvested. As interest rates rise, reinvestment opportunities improve, potentially offsetting the effect of price declines – at least over five-year periods.
The Bottom Line for Bond Investors
Given uninspiring return projections, what's a bond investor to do? One option is to seek higher yields from non-Treasury securities, such as corporates. The average investment-grade corporate bond currently yields about 1.4% more than a Treasury note of comparable maturity. Of course, corporates involve some additional credit risk. Alternatively, investors who feel strongly that interest rates will rise might opt to temporarily shorten the duration of their bond portfolios to limit price declines. Leveraged loans, due to their floating rate nature, can be useful tools for reducing duration – understanding that loans are generally rated below investment grade and can be less liquid. Another option is to seek the help of professional managers who have shown the ability to generate above-market returns with prudent relative value strategies. However, the unfortunate final conclusion is that investors should probably reduce their expectations for bond portfolio returns for the intermediate time horizon.
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