Will Investors Find Reward in Higher Risk?
As we consider the outlook for the second half of the year, it is worth differentiating between those asset classes that appear to be offering sufficient prospective returns and those that offer insufficient compensation for the risks taken.
Risks with insufficient prospective return potential
Long-term Treasury bonds: Many forecasters have erroneously called for higher government bond yields over the past few years. Long-term interest rates are low versus their history, so it is understandable to expect upward mean reversion at some point. If long-term interest rates were to return to their level of 6% in 2000, then 10-Year Treasury bonds would lose 32% of their value. One need not believe that a spike in interest rates is imminent to see that a 2% yield is insufficient compensation for the risks involved.
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How to prepare for the second half of 2017
Eight months have passed since the US presidential elections. The market faced ups and downs and started rebounding when Trump was elected. A stronger economy, higher inflation, a rising dollar, a better job market, less regulation, and a shift from fiscal to monetary policy are some of the many expectations that people have from the new administration. These expectations drove investors towards the stock market. The US stock market, as represented by the S&P 500 Index (SPY) (SPX-Index), has rallied, gaining 10% in 2016 and 8% year-to-date in 2017 as of June 30, 2017.
With half of 2017 already over, the main focus of this series is on asset classes that compensate for the risk taken by investors and the asset classes that don’t. Let’s take a look at both.
What are the risks involved in long-term Treasury bonds?
In 2016, the global bond market offered low-to-negative yields with minimal returns from government bonds as well. Global benchmark yields also hit an all-time low towards the second half of 2016. Meanwhile, the stock of negatively yielding global bonds rose to $13.3 trillion. The US ten-year Treasury bond hit an all-time low of 1.4% in July 2016. This further led investors to flock away from the bond market and seek income elsewhere such as in the stock market, which led to the stock market rally.
After the ten-year Treasury yield hit record lows, the “bull run” trend in the US bond market (BND) (AGG) ended, as the chart above shows. The yield, however, started rising again after President Trump’s victory and expectations rose that his policies would boost the US economy. The current ten-year Treasury bond yield is 2.3%.
Higher inflation and a better job market forced the Fed to raise interest rates. After three rate hikes since December 2016, more rate hikes could be in the cards this year. Investors can look forward to higher returns on their investments with an increase in bond yields. The downside of the implementation of these policies could be higher spending that could further result in greater debt burden to the economy.
Doubts started developing about President Trump’s timing and lack of clarity on the implementation of policies. Some US sectors suffered as a result, leading investors to shift their interest back to the bond market despite the possibility of Fed rate hikes. However, if longer-term interest rates increase, it could cause the current value of longer-term bonds (TLT) to fall. So investors’ primary focus should be on getting compensated for the interest rate risk when considering investment in government bonds.
In the next article, we’ll see if betting against volatility is worth the risk.