July 8, 2013 10:05 am
Bond investors fear sharp rise in Treasury yields
Not since 1994 have bond investors felt this kind of heat, and for good reason.
The US Federal Reserve will soon wind down the biggest experiment in monetary policy since the Great Depression, a prospect that has many in the bond market nursing hefty losses as investors redeem their money from bond funds and crowd the exit route.
Having been weaned on record low bond yields thanks to the Fed’s huge purchases of Treasury and mortgage securities, investors are now focused on one crucial question: how high can bond yields rise?
The benchmark 10-year Treasury yield peaked above 2.75 per cent in Asian trading on Monday, up from 1.60 per cent at the end of April.
Such an explosive move over a relatively short period has spared few big bond funds that loaded up on government, inflation protected, mortgage and corporate debt securities as the Fed focused on suppressing yields at artificially low levels. Bond prices move inversely with yields.
The big worry is that the combination of an improving economy and less support from the Fed will provoke the bond market to price in a normalisation of rates, well before businesses and homebuyers can support higher interest rates.
In an economy growing at 2 per cent, with an inflation premium of 1.5 per cent, a normal rate for the 10-year Treasury could be 3.5 per cent.
The rejoinder from the Fed and long-term investors is that a reduction in the pace of “quantitative easing” is miles away from any actual tightening of interest rate policy that would mark the first concrete step towards a normalisation of bond yields.
And Kevin Logan, chief US economist at HSBC, believes that the negative effects of rising rates will be muted, for the same reason that lower rates proved less of a positive than in previous recoveries: “This was a financial recession so the drop in rates did not elicit the usual response, because there was too much debt already.”
Ultimately, the level of end demand in the economy will be more important, he says, which is why Friday’s robust June jobs report moved markets so sharply. Some strategists point out the post-data surge in Treasury yields came a day after the July 4 holiday, when many traders were out the office and liquidity was thin.
This week will be a key test of how markets might behave in the coming months. As yields have risen, investors have needed to sell more Treasuries to insulate their portfolios from larger losses.
This type of technical selling could easily spin out of control and push the 10-year yield well beyond 3 per cent.
“The end of the period could bring a substantial deleveraging across the bond market and you need to make sure you have the freedom to manage your portfolio through the volatility,” says Tad Rivelle, chief investment officer at TCW. His portfolio is orientated to short-dated bonds that are less sensitive to higher interest rates and he also holds floating rate securities.
Scott Minerd, global chief investment officer at Guggenheim, says there is a risk that the yield on 10-year Treasuries could rise above 3.25 per cent by the end of the summer, to as high as 3.50 per cent.
However, such a jump would be self-correcting, he says. “The housing market is already feeling the impact of higher mortgage rates and by August the full effect those rates have on housing affordability will begin to show up in economic data. Once the economy begins to cool, lower interest rates will follow.”
While volatility can climb a lot higher, a big difference with the experience of 1994 is that the Fed is not looking at tightening policy.
“So long as the Fed is not tightening, it places a cap on how high 10-year yields can rise,” says Zach Pandl, interest rate strategist at Columbia Management.
Still, the prospect of an end to the period of suppression of interest rates has released a coiled spring, with losses for investors growing. Bill Gross at Pimco, dubbed the “bond king”, has registered a loss of 3 per cent so far this year amid a record outflow of $9.9bn from his flagship bond fund during June.
“People will overstate that what’s going on in the bond markets is just an adjustment, but because we are in such a low interest rate environment, losses can be significantly higher,” says Rick Reider, co-head of Americas fixed income at BlackRock.
“Investors are starting to recognise bonds are not the safe asset they used to be. In a certain way, we may be entering a period in which volatility in fixed income markets is going to be harder to manage than volatility in equities.”
The challenge for bond investors is vividly illustrated by the loss of 3.45 per cent so far this year for their benchmark, the Barclays Aggregate US bond index. That represents the worst year-to-date loss since the bond meltdown of 1994. Right now, being bullish on Treasuries is the last thing many investors are willing to contemplate.
The US Federal Reserve will soon wind down the biggest experiment in monetary policy since the Great Depression, a prospect that has many in the bond market nursing hefty losses as investors redeem their money from bond funds and crowd the exit route.
Having been weaned on record low bond yields thanks to the Fed’s huge purchases of Treasury and mortgage securities, investors are now focused on one crucial question: how high can bond yields rise?
The benchmark 10-year Treasury yield peaked above 2.75 per cent in Asian trading on Monday, up from 1.60 per cent at the end of April.
Such an explosive move over a relatively short period has spared few big bond funds that loaded up on government, inflation protected, mortgage and corporate debt securities as the Fed focused on suppressing yields at artificially low levels. Bond prices move inversely with yields.
The big worry is that the combination of an improving economy and less support from the Fed will provoke the bond market to price in a normalisation of rates, well before businesses and homebuyers can support higher interest rates.
In an economy growing at 2 per cent, with an inflation premium of 1.5 per cent, a normal rate for the 10-year Treasury could be 3.5 per cent.
The rejoinder from the Fed and long-term investors is that a reduction in the pace of “quantitative easing” is miles away from any actual tightening of interest rate policy that would mark the first concrete step towards a normalisation of bond yields.
And Kevin Logan, chief US economist at HSBC, believes that the negative effects of rising rates will be muted, for the same reason that lower rates proved less of a positive than in previous recoveries: “This was a financial recession so the drop in rates did not elicit the usual response, because there was too much debt already.”
Ultimately, the level of end demand in the economy will be more important, he says, which is why Friday’s robust June jobs report moved markets so sharply. Some strategists point out the post-data surge in Treasury yields came a day after the July 4 holiday, when many traders were out the office and liquidity was thin.
This week will be a key test of how markets might behave in the coming months. As yields have risen, investors have needed to sell more Treasuries to insulate their portfolios from larger losses.
This type of technical selling could easily spin out of control and push the 10-year yield well beyond 3 per cent.
“The end of the period could bring a substantial deleveraging across the bond market and you need to make sure you have the freedom to manage your portfolio through the volatility,” says Tad Rivelle, chief investment officer at TCW. His portfolio is orientated to short-dated bonds that are less sensitive to higher interest rates and he also holds floating rate securities.
Scott Minerd, global chief investment officer at Guggenheim, says there is a risk that the yield on 10-year Treasuries could rise above 3.25 per cent by the end of the summer, to as high as 3.50 per cent.
While volatility can climb a lot higher, a big difference with the experience of 1994 is that the Fed is not looking at tightening policy.
“So long as the Fed is not tightening, it places a cap on how high 10-year yields can rise,” says Zach Pandl, interest rate strategist at Columbia Management.
Still, the prospect of an end to the period of suppression of interest rates has released a coiled spring, with losses for investors growing. Bill Gross at Pimco, dubbed the “bond king”, has registered a loss of 3 per cent so far this year amid a record outflow of $9.9bn from his flagship bond fund during June.
“People will overstate that what’s going on in the bond markets is just an adjustment, but because we are in such a low interest rate environment, losses can be significantly higher,” says Rick Reider, co-head of Americas fixed income at BlackRock.
“Investors are starting to recognise bonds are not the safe asset they used to be. In a certain way, we may be entering a period in which volatility in fixed income markets is going to be harder to manage than volatility in equities.”
The challenge for bond investors is vividly illustrated by the loss of 3.45 per cent so far this year for their benchmark, the Barclays Aggregate US bond index. That represents the worst year-to-date loss since the bond meltdown of 1994. Right now, being bullish on Treasuries is the last thing many investors are willing to contemplate.
Copyright The Financial Times Limited 2013.
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