A reality check hits the bond market: the economy could be headed for a “no landing” scenario, prompting the Federal Reserve to apply the brakes more than previously anticipated.
The prospect of higher interest rates — the Fed’s primary policy tool to slow economic growth and contain inflation — has sent bonds tumbling in recent weeks. A recovery could be difficult in the coming months. High-quality short-term debt, such as Treasuries that yield 5%, can be a good way to weather volatility and generate positive total returns.
Bond prices and yields are moving in opposite directions and the past few weeks have been brutal as yields have soared. The 10-year government bond yield started February at 3.39%. It recently traded at around 3.94%, a big jump in a short amount of time.
The headwind has swept through the market. The
iShares Core US Aggregate Bond
Exchange Traded Fund (ticker: AGG) was up 4% including interest at the end of January. It’s now up just 0.6%, giving up nearly all of its year-to-date gains.
The bond market seems concerned that inflation is not cooling nearly fast enough to reach the Fed’s comfort zone at an annualized rate of 2%. The job market also remains buoyant, pointing to a “no landing” scenario in which the economy resists Fed efforts to slow growth.
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In addition, bond markets are pricing in inflation expectations in excess of what the data suggests. Nicholas Colas, co-founder of DataTrek Research, points out that since mid-January, five-year Treasury bond yields are up 74 basis points (one basis point is 1/100 percent). However, five-year inflation expectations have only risen by 0.43 percentage points.
The larger jump in yields suggests investors are demanding higher inflation-adjusted yields, he says. “In other words, the recent rise in yields isn’t just related to inflation,” he adds. “Rather, it’s a sign that investors are becoming more risk-averse.”
Given the uncertainty surrounding inflation and the Fed’s rate plans, some strategists are recommending playing it safe with debt such as 6-month Treasury bills, which are now yielding 5.1%. That’s not much of a positive “real” return, adjusted for inflation. But if you hold the bills to maturity, you’re guaranteed that return with no capital risk, assuming the US government doesn’t default.
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“You get an excellent, high-quality, short-dated asset, so you don’t have too much exposure to volatility, and you get the best forward-looking returns we’ve had in a decade,” said Ed Al-Hussainy, senior interest-rate strategist at Columbia Threadneedle. “That’s a pretty good deal to be able to include that,” he adds.
Corporate bonds outperform government bonds, although most bond funds have a longer duration, or interest rate risk, than T-bills.
Vanguard Short Term Corporate Bond
ETF (VCSH), for example, has a 30-day SEC yield of 4.94%. But its average duration of 2.7 years makes it a little riskier if rates continue to rise. The ETF, which tracks the Bloomberg US 1-5 Year Corporate Bond Index, is up 0.4% this year including interest rates.
High-yield or “junk” bonds could be good, with yields around 7.8% for funds such as
iShares iBoxx High Yield Corporate Bond
(HYG). But the ETF carries significant credit risk and is an interest rate game with an effective duration of 3.9 years. It’s up just 0.8% this year in terms of total returns.
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Some strategists see little profit in tricky corporate bonds. “Don’t go too far down on the credit rating; They’ll have a better opportunity to get in later,” said Brian Rehling, head of global fixed income strategy at Wells Fargo Investment Institute.
write to Carleton English at [email protected]
