Key strategy: Will deflation contain the bear market in bonds? (Part 2 of 6)
Real interest rates
The below graph reflects the real interest rate in both the ten-year U.S. Treasury bond and in Federal Funds deposit rates—overnight deposits. It’s important to note that real yields in the U.S. ten-year bond are really not that low on a real basis. At the end of 2013, the ten-year bond had a yield of roughly 3%, while inflation was running at close to 1%, netting a real yield of roughly 2%—not terribly out of line with post-1990 levels. As the below graph shows, when the Federal Reserve Bank lowers its Fed Funds interest rate, there’s some lag in the long-term ten-year rates moving higher as the economy recovers.
This article examines the dynamic of real interest rates in the USA and the 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.
Negative real interest rates
In order to spur the economy post–2008 crisis, the Federal Reserve Bank lowered its overnight deposit rate to nearly zero, or 0.10%. After subtracting the inflation rate, as reflected in the U.S. Consumer Price Index, or CPI, we see that the real yield on the Federal Funds rate has remained in negative territory for some time. The actualization of negative real interest rates serves as a stimulus for savers to invest rather than to simply sit on their money and incur an associated decline in their savings’ value commensurate with the negative real interest rate. Typically, these low rates—and especially negative rates—push capital into new investments, which in turn leads to an economic recovery.
What’s different this time?
While the low interest rate environment in the U.S. has contributed to record corporate profits and rising stock prices, it would appear that there hasn’t been a significant recovery in investment required to lead to a strong recovery in economic growth. As we pointed out in an earlier series, it might appear that capital has “gone on strike,” and reinvestment in fixed, long-term investments isn’t occurring as much as it had in prior economic recoveries. For further analysis of the lack of fixed investment in the current economic recovery, please see the related series U.S. investment: Have capitalists gone on strike?
For fixed income investors
For fixed income investors, deflation and the low interest rates that typically accompany deflation are bond price–friendly. However, should the Federal Reserve Bank succeed in reaching its inflation target of 2.0% or slightly higher, the real overnight rate of Federal Funds deposits could become even more negative, and increased inflation levels could trickle into longer-dated bonds. This development would likely lead to significant price declines in long-dated bonds and long-duration ETFs, such as TLT.
To see how the Federal Reserve Bank’s $4 trillion in asset purchases is impacting 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 A flagging consumer price index contains the bear market in bonds.
Outlook: High credit quality and longer duration (TLT & BND) versus lower credit quality and mid duration (HYG & JNK)
For fixed income investors concerned with rising interest rates and falling bond prices, long-dated (long duration) ETFs such as the iShares 20+Year Treasury Bond ETF (TLT) may continue to see price declines if interest rates continue to rise. Note that the TLT ETF has a duration of approximately 16.35 years—roughly twice that of the current ten-year Treasury bond at 8.68 years. In contrast to the long-dated TLT, the iShares iBoxx High Yield Corporate Bond ETF, HYG, has a much shorter duration of only 3.98 years, as well as exposure to improving commercial credit markets, and may continue to outperform the long duration TLT ETF in a rising rate environment.
However, investors should note that the High Yield portfolio of HYG holds roughly 90% of its portfolio in bonds rated BBB3 through B3, with roughly 10% of its portfolio in CCC-rated credit (substantial risks). HYG top holding includes Sprint Corp (S) at 0.56% of the portfolio. The Vanguard Total Bond Market ETF (BND) maintains a duration of 5.5 years, though it holds 65.4% of its portfolio in government bonds and 21% of his holdings in AAA–A rated bonds. Compared to HYG and JNK, the BND ETF is slightly longer in duration (BND 5.5 years versus HYG 3.98 and JNK 4.20). But it’s very much concentrated in government and high-quality bonds, and will therefore be less impacted by changes in the overall commercial credit markets
Lastly, for investors looking to maintain yield while gaining exposure to the commercial credit market, an alternative to the iShares HYG, the Barclays High Yield Bond Fund ETF (JNK), offers a similar duration of 4.20 years versus HYG’s 3.98 years, holding 84.17% of its portfolio in corporate industrial, 7.65% in corporate utility, and 7.5% in corporate finance-oriented bonds. Like JNK, HYG is also a big fan of Sprint Corp. (S)(0.62%) and First Data Corp. (0.44%), and it also holds CIT Group (CIT)(0.26%), Caesars Entertainment (CZR)(0.24%), T-Mobile USA (TMUS)(0.24%), Tenet Healthcare (THC)(0.24%), Ally Financial (ALLY)(0.23%), and SLM Corporation (SLM)(0.22%).
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