Is the 10-year bond a case of low yields or simply low inflation?



The 10-year bond

The below graph reflects the long-term decline in the yield of the ten-year U.S. Treasury bond. This is an important bond, as it is widely used to both price and hedge mortgages in the USA. Low mortgage rates in recent years have been driven by the low rate of the ten-year Treasury bond yields. These low rates have translated into lower mortgage rates, widespread mortgage refinancing at lower rates, and thereby more cash left over at the end of the month for both individuals and corporations, which have long-term debt payments to make. This has helped improve cash flow to both individual and corporate balance sheets, and helped take some of the pain out of the recent recession, which was accompanied by slower-than-normal economic growth.

This article considers the decline in long-term U.S. interest rates 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.

Why the ten-year bond rate has been low

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The ten-year Treasury bond yields have been low as a result of the global recession and declines in both equity and housing markets in the past. These events encouraged investors to seek safety in their investments and avoid the risk of losing principal in their investments. Plus, inflation has declined dramatically, while the Federal Reserve Bank has purchased record levels of bonds in order to push inflation back toward its targeted 2.0% comfort zone, which is more consistent with stable economic growth.

Why ten-year bond yields are rising

The ten-year bond ended 2013 at 3.0% as a result of the Federal Reserve Bank’s announcement that it would scale back bond purchases from $85 billion to $75 billion per month, as economic indicators suggested that the U.S. economy had moved out of the crisis zone. While buying $75 billion of both Treasury and mortgage-backed bonds is still a very accommodative policy by historical standards, this change in policy served as an important signal that a self-sustaining recovery could be on the way.

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Also, as equity markets and corporate profits have run to record-high levels and government tax receipts have been robust, it might appear that the Federal Reserve Bank need not provide so much support to keep interest rates as low as they’ve been since 2009. As a result, the ten-year bond yield, at least at around 3.0%, has returned to its historical trend line, as noted in the above graph. Looking forward, investors will need to monitor whether the 3.0% yield level will become a “ceiling” to future rates, or if economic growth, in conjunction with less Federal Reserve Bank accommodation, will render the 3.0% yield level a “floor” to the ten-year rate going forward.

Should economic recovery and inflation data increase, it’s quite possible the 3.0% yield seen at the end of 2013 may become a near-term floor. Should the 3.0% level become the new floor to the ten-year Treasury bond yield, fixed income investors with exposure to the ten-year and longer-dated bonds would be unable to expect future price gains in their fixed income holdings, and would more likely incur losses in the prices of long-term bonds or ETFs containing long-term bonds, such as TLT, should rates move higher.

To see how the Federal Reserve Bank’s zero interest rate policy is affecting 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 Fixed income ETFs: Short-duration alternatives for bonds.

Outlook: High credit quality and longer-duration (TLT & BND) versus lower credit quality and mid-duration (HYG & JNK)

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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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