U.S. Markets closed

The US 10-year bond: Why low inflation contains the bear market

Marc Wiersum, MBA

Fixed income ETFs: Short-duration alternatives for bonds (Part 4 of 5)

(Continued from Part 3)

The ten-year U.S. Treasury bond

The below graph reflects the long-term decline in the yield of the ten-year U.S. Treasury bond. This is an important bond, as it’s widely used to both price and hedge mortgages in the USA. Low mortgage rates in recent years have been driven by the low rate of the ten-year Treasury bond yields. These low rates have translated into lower mortgage rates and widespread mortgage refinancing at lower rates, and therefore more cash left over at the end of the month for both individuals and corporations, which have long-term debt payments to make. This has helped improve cash flow to both individual and corporate balance sheets and helped take some of the pain out of the recent recession, which was accompanied by slower-than-normal economic growth.

This article considers the ongoing decline in the ten-year interest rate and considers implications for fixed income investors. For a detailed analysis of the U.S. macroeconomic environment supporting this series, please see Must-know 2014 US macro outlook: The crack in the debt ceiling.

Why the ten-year bond rate has been low

The ten-year Treasury bond yields have been low as a result of the global recession and past declines in both equity and housing markets. These events encouraged investors to seek safety in their investments and avoid the risk of losing principal in their investments. Plus, inflation has declined dramatically, while the Federal Reserve Bank has purchased record levels of bonds in order to push inflation back toward its targeted 2.0% comfort zone, which is more consistent with stable economic growth.

Why ten-year bond yields are going higher

The ten-year bond ended 2013 at 3% as a result of the Federal Reserve Bank’s announcement that it would scale back bond purchases from $85 billion to $75 billion per month, as economic indicators suggested that the U.S. economy had moved out of the crisis zone. While buying $75 billion of both Treasury and mortgage-backed bonds is still a very accommodative policy by historical standards, this change in policy served as an important signal that a self-sustaining recovery could be on the way.

Plus, as equity markets and corporate profits have run to record high levels, and government tax receipts have been robust, it might appear that the Federal Reserve Bank need not provide so much support to keep interest rates as low as they have been since 2009. As a result, the ten-year bond yield, at least at around 3.0%, has returned to its historical trend line, as noted in the above graph. Looking forward, investors will need to monitor whether the 3.0% yield level will become a “ceiling” to future rates, or whether economic growth, in conjunction with less Federal Reserve Bank accommodation, will render the 3.0% yield level a “floor” to the ten-year rate going forward.

Should economic recovery and inflation data increase, it’s quite possible the 3.0% yield seen at the end of 2013 may become a near-term floor. Should the 3.0% level become the new floor to the ten-year Treasury bond yield, fixed income investors with exposure to the ten-year and longer-dated bonds would be unable to expect future price gains in their fixed income holdings, and would more likely incur losses in the prices of long-term bonds or ETFs containing long-term bonds, such as TLT, if rates move higher.

To see how the Federal Reserve Bank’s low interest rate policies affect bond yields, please see the next article in this series.

For additional analysis related to other key fixed income ETF tickers, please see the related series Fixed income ETF must-know: Has the bear market in bonds begun?

Short duration, higher credit risk: SNLN & BKLN

If investors are concerned about a rising rate environment, they may wish to consider short-duration fixed income exposure through short-duration fixed income ETFs such as the Highland/iBoxx Senior Loan ETF (SNLN). This ETF holds senior bank loans, which offer a floating rate coupon based on short-term interest rate pricing—which is typically the 90-day interbank rate, known as “three-month LIBOR.” (LIBOR stands for the “London Interbank Offer Rate on Deposits,” and it’s established daily through a consortium of banks under the British Banker’s Association in London.)

Similarly, the Invesco PowerShares Senior Loan Portfolio ETF (BKLN) also holds senior bank loans and also has a short duration. The duration of these “floating rate” loans is typically 40 to 60 days—much shorter duration than the typical four-year duration associated with similar corporate five-year bond portfolios. The loan portfolios also carry an additional advantage over longer-duration corporate bonds in that they have a much higher average recovery of loss rate compared to corporate bonds—closer to 80% compared to closer to 50% in the case of similar rated bonds.

It’s important to note that both these ETFs invest in loans that are rated in the BBB-B area and they involve more risk of loss than portfolios rated in the AAA-A area. However, what they lack in credit rating they tend to compensate for in terms of higher returns. SNLN offers a yield-to-maturity of around 4.8%, and BKLN around 4.95%.

Longer-duration, lower-credit-risk alternatives: AGG & LQD

If you’re wary of credit risk, you could also consider longer-duration ETFs such as the iShares Core Total U.S. Bond Market ETF (AGG). It maintains a duration of 5.11 years, though it has a yield-to-maturity of 2.14%, as it holds roughly 70% of its portfolio in AAA and AA rated bonds. Similarly, the iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD) offers a duration of 7.49 years and a 3.35 yield-to-maturity, and it holds the majority of its bonds in the A to BBB category. Like LQD, AGG also holds high-quality commercial credits, such as Verizon (VZ)(0.09%) and GE Corporation (GE)(0.08%). Like SNLN, BKLN also holds lower-rated commercial credits, such as Fortescue Metals Group (FMG)(1.96%) and Valeant Pharmaceuticals (VRX)(1.48%). Note that the individual holdings of BKLN and SNLN are much larger than the holdings of the higher-credit-quality holdings of LQG and AGG, reflecting the greater diversification and the lower level of default-related losses associated with AGG and LQD.

Continue to Part 5

Browse this series on Market Realist: