For years, the talk in the financial markets was that U.S. interest rates couldn’t go lower because the economy was gaining strength, and once the Federal Reserve raised rates in December for the first time in almost 10 years that forecast seemed correct. It wasn’t.
Although short-term rates today are higher than they were a year ago, they’ve fallen in the past month, and long-term rates are lower all around, a full 1% lower for the 10-year and 30-year Treasury bond.
In fact, in midday trading Monday, the yield on the 10-year Treasury slid to 1.37%, a record low.
You could blame the decline in yields on Brexit and the rush to quality, safe-haven investments like U.S. Treasuries, but then you’d be missing the full story. Even before Brexit long-term U.S. rates were falling and since late January have remained under 2%.
“Rates will be low for a long time,” says Rick Rieder, chief investment officer of global fixed income at BlackRock, who was one of several panelists discussing the bond market outlook at a recent UBS 2016 CIO Global Forum in New York.
Rieder said the yield on the 10-year Treasury note, which was trading at 1.48% when he spoke, could fall another 25 basis points given the “extraordinary” demand from overseas buyers post-Brexit.
Lower yields don’t just mean less income for investors but also more risk if interest rates rise; bonds with lower coupons lose more value when rates rise.
‘The downside of being wrong can be material,” said Mike Swell, who is the co-head of global fixed income portfolio management at Goldman Sachs Asset Management. “Think about the potential for being wrong. It’s not out of the question that in 2017 the Fed acts more aggressively [due to] a very tight labor market in the U.S.”
An aggressive Fed may not be out of the question for next year but seems to be more than unlikely this year, given Brexit and slowing economic growth in the U.S. and abroad.
Schwab’s chief investment strategist, Liz Ann Sonders, in the firm’s latest midyear market outlook, writes that weak growth in the U.S., coupled with “deteriorating financial conditions associated with …. Brexit” will keep the Fed on the sidelines for the remainder of the year.
Continued low global interest rates are “the biggest risk” now for U.S. bond investors, said Lyle Fitterer, head of tax-exempt fixed income at Wells Fargo Asset Management, at the UBS Forum. He noted that low rates are especially negative for the banking and insurance sectors so long as the yield curve — the difference in yields between short- and long-term debt — remains relatively flat.
But Fitterer is positive on the muni market which he said has been benefiting from strong demand, including purchases from foreign investors buying both taxable and tax-exempt munis. Even though those investors can’t benefit from the higher tax-equivalent yields of tax-exempt bonds – because they’re not U.S. taxpayers – they still earn a positive yield, which is higher than negative yields at home.
“Short-term munis are an especially “attractive” as a “place to hang out,” says Fitterer, noting that there are “good credits” in some “bad” muni markets such as New Jersey and Illinois.
All the bond market panelists warned about chasing yield in the current low-yield market, as many have been warning for the past year. Higher yields expose investors to more credit risk, which may make sense when the outlook calls for a strong economy, but that’s not the case now.
“We are in the late stage of the credit cycle” characterized by increasing leverage, narrower corporate profit margins and a growing irregularities, which are traditionally indicators of a future recession and raise concerns about companies keeping up with their debt obligations, said Goldman’s Swell. Chasing yield “doesn’t end well.”
Rieder of BlackRock counseled bond investors to “diversify fixed income assets like crazy,” making sure to collect some yield.
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