Bond Market Commentary

Eight and half years later…are you still waiting?

By Doug Drabik
May 22, 2017

Quantitative easing (QE1) was first announced at the end of 2008. This monetary policy was intended to stimulate the economy following the 2007-2008 financial crisis that plagued the US. When the Fed first announced plans to purchase bonds in the open market, the 1-year Treasury rate was 0.939%, the 10-year was 3.108% and the 30-year was 3.619%. Part of the policy involved Zero Interest Rate Policy (ZIRP) where the Fed targeted federal funds to it lowest effective rate.

QE2, Operation Twist and QE3 followed between November, 2011 and October, 2014 when the Fed finally ended its monthly open market asset purchases. For the six year period marked from the beginning of QE1 to the end of QE3, every yield curve point was within 85bp from where it started.

QE1 Announced QE3 Ends
Treasury Yields 11/25/08 10/31/14 5/22/17
1mo 0.030 -0.005 0.685
1yr 0.939 0.091 1.093
2yr 1.179 0.491 1.283
3yr 1.426 0.921 1.454
5yr 2.033 1.610 1.790
10yr 3.108 2.335 2.247
30yr 3.619 3.066 2.909

Source: Bloomberg LP, Raymond James

The Fed stopped its open market purchases but has not moved the overall policy to one of tightening either. Since the end of QE3, only the 1 year Treasury has managed to land 100bp from October, 2014 and over the 8.5 year period from the announced QE1 to today, the widest difference is the 10-year which is down 86bp. The 1-year is 15bp higher providing a resiliently tight ranged slightly less sloped yield curve.

It seems as though year-after-year the entire financial world of experts calls for higher rates and more Fed hikes to monitor the upcoming robust economy. What is delivered is modest US economic growth, much uncertainty and a couple of controversial Fed hikes. In the end, not much has changed.

Perhaps the headwinds have been largely under-rated. The economic numbers have been wildly mixed as to the state of the economy. There has been no consistency. Global interest rate disparity has not eased at all. The US rates clearly are attractive to nearly all economic powers where interest rates remain net zero and even negative. Now politics are proving far more spirited than anticipated and promised policies clearly will take much longer to enact if they can be passed at all. In addition undertones of demographic behavior loiter and may keep consumer activity low regardless of monetary or fiscal policies.

As the economy, political environment and global state stand, it would be difficult to assume interest rates will change much from tight 8.5 year range they’ve been in. Bonds continually prove to be about long-range planning and long-term benefits. Waiting for what is considered a perfect moment might prove to be a futile exercise.


Let’s get real

By Benjamin Streed, CFA
May 15, 2017

Something very interesting is happening in the US bond markets, but you have to dig deep to notice it. When discussing yields one must be careful to differentiate between nominal, or stated yield, and the real yield which takes into account the negative effect of inflation on investment returns. Put simply, the nominal rate less inflation equals an investor’s real yield. Obviously, high nominal yields are wonderful but when paired with high inflation you end up with a low real yield, not ideal by any stretch of the imagination. In the United States, 10 year real yields have been falling for decades since they topped out in the 1980s, falling from over 8% to zero (or even negative) in recent years as inflation remains muted. Interestingly, low real yields are not unique to the US. Globally, there is a clear trend for developed economies, one pointing toward subdued real yields.

If these real yields seem low, it’s because they are. Developed countries around the world currently have real 10yr rates ranging from negative 1.27% in Germany up to as much as 0.40% here in the United States. Canada is in the middle of the pack at zero percent while the Eurozone as a whole is well below zero. To rephrase this point for emphasis, at ~40 basis points the US has the highest real rate of interest in the developed world. Investors in the current market environment do not demand much above the core rate of inflation to own longer-dated US Treasuries.

Friday’s weaker than anticipated inflation data reminded markets that core prices remain stubbornly low despite the ongoing strength of the US consumer and generally positive broad economic data. Slow and steady appears to be the base case scenario for the US economy, which given the context of slow global growth looks pretty good in comparison. Interestingly, in recent months the real yield in the US has been increasing slightly, up from a low of negative 0.8% back in mid-2016, but what’s the cause? Since February of last year the inflation component of the 10yr Treasury has declined, showing that expectations for rising inflation are waning (top pane, white line). Meanwhile, the stated/nominal yield remains range bound in the 2.25-2.50% area (yellow line below). Put those two together and you have rising real rates despite a nominal yield that hasn’t moved much. Remember, nominal yield (2.33%) less inflation (1.88%) equals the real yield (roughly 0.40%), which is on the rise despite the seemingly calm state of the bond markets. At the end of the day, there continues to be strong, ongoing demand for high-quality, income producing assets like US Treasuries and investment grade bonds. This demand is global and is a result of a number of factors including aging populations in the developed world and a global savings glut that shows no signs of slowing down. This trend is decades in the making and emphasizes the clear willingness of many investors to seek out the safety of fixed income securities in their investment portfolios.


Why do I own bonds?

By Doug Drabik
May 8, 2017

To fixed income gurus, the question, “Why do I own bonds” may feel much like fielding the question, “Why do I breathe”. The quick answer is, “I need to in order to survive.” OK, breathing is a critical exercise in providing physically existence but owning bonds can be likened to providing wealth sustenance. Often asset allocation is treated as if it were a contest or show of dominance by pitting one asset class against the other. It’s not a contest but a welcome accord. The truth is that a healthy portfolio depends on various asset classes to optimize a hearty life. Various assets such as MLPs, equities, real estate or alternative investments tend to carry higher risk levels but also carry higher potentials for growth. If these asset classes perform well, another portion of the portfolio, bonds, may provide the best means to safeguard that accumulated wealth.

We’ve heard this before but what if rates stay low? How do I justify putting anything into bonds? First of all, rates are and have stayed low. A point of importance is that the ‘low’ rates we are labelling refers to nominal interest rates (i.e. the actual yield bonds are paying). By recent historic norms, real interest rates (yields earned after inflation), reflect a different picture. Although interest rates have declined, so has inflation. Under the current environment nominal and real interest rate variance is narrower than the appearance of solely focusing on nominal rates. So as we make the point about investing in a lower rate environment, investors should be mindful that the ‘higher rates’ earned in the past were somewhat offset by the higher inflation eroding the return.

To make the point, an extreme period would be on March 31, 1980. The 10-year Treasury rate was 12.64%. Most investors would be quite excited to see this rate today, especially on a high credit-quality bond; however, although the nominal rate was 12.64%, it was coupled with 14.8% inflation. The real rate of return was actually -2.16%. For 2 decades between 1980-2000, the 10-year averaged 8.62% but inflation averaged 4.3% bringing real rates closer to a 4.3% average.

Interest rates have been on a general decline for over 35.6 years but with the critical distinction between nominal and real rates addressed, the importance of investing in bonds even when nominal rates are low remains a key component of investing success. There is a protection gained from bonds when interest rates decline. It is called appreciation. Nice but not vital to the characteristics a well-diversified portfolio of higher quality individual bonds serve within most of our clients’ portfolios. The conservative nature built into bonds is threefold: 1) bonds provide a defined cash flow, 2) bonds provide a predictable income stream and 3) bonds decree a stated date for the return of face value. These three characteristics are what create the conservative nature of bonds.

Investors may fall into the trap that low durations are intrinsically “conservative”; however, bonds interact with the other components (asset classes) to provide their safeguard benefits. Bonds with higher duration are more likely to be non-correlated to equities, thereby more likely to hold up during periods of time when equities or other growth assets are getting battered by the market. This becomes even more imperative when the asset allocation mix of a portfolio is especially over-weighted with one type of asset class. When interest rates rise, this point is emphasized by the idea that as long as an investor holds onto their bonds, none of these bond qualities (cash flow, income or maturity) are altered regardless of changes in interest rates.

Interest rate risks are always present regardless of where current interest rates reside; however, there may be a higher risk associated with leaving growth assets unprotected than by potential opportunity risks lost when or if interest rates rise. A balance of asset classes providing the benefits of appropriate bond characteristics within the fixed income portion may prove to be one of the better investment opportunities available to optimize portfolio return while protecting amassed wealth. This is why one owns bonds!

Treasury Yields 12/30/16 05/08/17 Net Chg
1mo 0.416% 0.685% +27bp
1yr 0.811% 1.099% +29bp
2yr 1.188% 1.322% +13bp
3yr 1.451% 1.511% +6bp
5yr 1.927% 1.880% -5bp
7yr 2.245% 2.160% -9bp
10yr 2.444% 2.349% -10bp
30yr 3.065% 2.986% -8bp

Source: Bloomberg LP, Raymond James


To learn more about the risks and rewards of investing in fixed income, please access the Securities Industry and Financial Markets Association’s “Learn More” section of investinginbonds.com, FINRA’s “Smart Bond Investing” section of finra.org, and the Municipal Securities Rulemaking Board’s (MSRB) Electronic Municipal Market Access System (EMMA) “Education Center” section of emma.msrb.org.

The author of this material is a Trader in the Fixed Income Department of Raymond James & Associates (RJA), and is not an Analyst. Any opinions expressed may differ from opinions expressed by other departments of RJA, including our Equity Research Department, and are subject to change without notice. The data and information contained herein was obtained from sources considered to be reliable, but RJA does not guarantee its accuracy and/or completeness. Neither the information nor any opinions expressed constitute a solicitation for the purchase or sale of any security referred to herein. This material may include analysis of sectors, securities and/or derivatives that RJA may have positions, long or short, held proprietarily. RJA or its affiliates may execute transactions which may not be consistent with the report’s conclusions. RJA may also have performed investment banking services for the issuers of such securities. Investors should discuss the risks inherent in bonds with their Raymond James Financial Advisor. Risks include, but are not limited to, changes in interest rates, liquidity, credit quality, volatility, and duration. Past performance is no assurance of future results.