The Quiet Bear Market in Bonds
Don't be fooled by the surprising rally in bonds after the Federal Reserve raised interest rates and signaled that at least two more increases are likely to happen before the year is over. The quiet bear market that has been under way since yields bottomed in mid-2016 is alive and well.
The way to think about this bear market is not in terms of yield levels, which remain relatively low on an absolute basis, but rather in terms of expected returns. It's on that basis that investors face a trifecta of worrisome metrics that should curb gains going forward: rising forward rates, flat yield curves and low term premiums.
Students of the bond market are familiar with the “expectations theory,” which says that forward rates are essentially the sum short-term spot rates over some period of time. With the Fed intending to hike short-term rates more sequentially, longer maturity spot rates may match the level of forward rates, resulting in zero or even negative expected bond returns
That was on full display when Fed officials came out in force early this month to strongly signal that they would be raising rates on March 15. Investors responded by pushing the five-year forward rate above 3 percent, while the “term premium” -- or, the excess return investors get by owning longer maturity bonds instead of short-term ones -- fell. In the past, a combination of higher forward rates and low term premium resulted in negative returns as measured by the Bloomberg Barclays Global Treasury Index.
Eugene Fama, the University of Chicago finance professor, proved the “expectations theory” in his groundbreaking research on spot and forward rates. That leads us to the worrisome second metric. As part of his evidence, Fama showed that when the difference between short- and long-term bond yields is wide -- which traders call a steep yield curve -- there is a measurable difference in average future returns between shorter and longer maturity bonds. When the curve is flat, differences in returns are smaller. History in Figure 2 shows that the yield curve tends to narrow when the Fed embarks on a series of rate increases.
The third metric, term premiums, can be explained through concepts that are key to bond returns are known as “carry” and “roll down.” Carry is the difference between yields and overnight rates. Put another way, it's what one earns by borrowing at overnight rates and investing the proceeds in bonds. Roll down is the return generated from the slope of the yield curve. In other words, an investor who buys a three-year Treasury note can holds it for 12 months would then be essentially holding a two-year note at a lower yield. Returns from this strategy work best when the yields are high and the curve is steep. But the problem facing investors today is that yields are relatively low, and the returns one can expect from executing the strategy with developed market sovereign bonds have diminished to a small number of basis points.
The table below breaks down the carry and roll down returns in basis points per unit of duration risk. The combined return of carry and roll down in Japan and Europe is very small at just 2 to 3 basis points, even with the recent steepening in yield curves. The carry and roll down return also diminishes further out the yield curve. The low level of carry and roll down suggests that expected returns on government bonds may dwindle with more Fed rate hikes.
Investment-grade corporate bonds provide only slightly more relief. Credit spreads per unit of duration risk is currently around 15 basis points across many sectors. The low compensation per unit of credit risk shows that investors must be much more selective than they have in the past when choosing which bonds to own, especially when financial conditions tighten because of higher rates.
There is an added layer of complexity for global bond investors, who must consider fluctuations in foreign-exchange rates. Let's start with the return of currencies, which is measured by the “FX implied yield.” That's the difference between FX spot rates and FX forward rates. Expected returns in emerging-market currencies remain relatively high between 5 percent and 10 percent. Implied FX rates of developed currencies such as the euro, yen, Swiss franc and British pound are mostly negative by 0.5 percent. With a return differential of more than 6 percent, bond investors can seek some comfort from better expected returns in emerging markets.
It won't be long before major central banks join the Fed and start tightening monetary policy, raising the risk of losses on bonds as expected short-term interest rates drive up long term forward rates. Outside of U.S. Treasuries, markets prone to that risk include European sovereign debt. Markets with falling spot rates and steeper yield curves may see those translate into higher expected returns, namely in emerging markets and specialized areas of the credit market. Picking the right bonds to own is becoming a much tougher challenge.
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