Are US Treasury Yields Following Japan & Europe to Zero?

The second quarter of 2016 was another solid quarter for US bonds. The Barclays Aggregate Index (the broad measure of investment grade debt) returned 2.33% for the period. So far this year, the index is up 5.36%, making bonds one of the strongest performing asset classes in the first half of 2016. While it is nice for bond investors to enjoy such a strong performance in that part of their portfolios, it is always good to be reminded that the bulk of the return from a bond comes from coupon income. Also, keep in mind that declining yields causes prices on existing bonds to rise, resulting in lower future yields and future returns.

Not only have yields declined, but maturities 10 years and beyond are approaching the lows reached in 2009. While some of the most recent decline can be attributed to the flight to US Treasury securities by investors concerned about the fallout from the Brexit vote in the U.K., there is more at work as indicated by the compression of break-even yields between UST inflation protected bonds and UST nominal bonds – sometimes called the breakeven inflation rate. Even the release of the minutes from the most recent meeting of the policy making body of the Federal Reserve Bank mentioned concern about deflationary pressures that appear to be making their way back into the market. The chart below shows the level of the breakeven inflation rate for the past 10 years. Despite the quantitative easing program(s) and efforts by central banks around the world to reignite economic growth and with it inflation, the decline since 2013 suggests that deflationary pressures are real and pervasive.

Image from fred.stlouisfed.org

5-Year Breakeven Inflation Rates Image from fred.stlouisfed.org

With countries like Japan, Germany, and Switzerland already possessing negative interest rates as far out the yield curve as 10 years, some investors and policy makers are asking if the U.S. can be that far behind? While negative nominal treasury yields are possible in the US, this is very unlikely - barring a serious slowdown in U.S. economic growth. Additionally, if U.S. growth accelerates in the second half of 2016 as a number of forecasters expect, we could actually see US Treasury yields rebound from the current lows. That said, the longer term pressures that are impacting Europe and Japan are very real and will continue to act as a headwind, keeping US rates at or near historic lows.

While US Treasury yields are near their historic lows, the spread widening that occurred in both investment grade and high yield corporates over the past 6 months has left some attractive values for investors seeking greater yields. This is noticeably true as one looks further out the yield curve. For a number of solid investment grade credits, the spread between a 5 year debt offering and 30 year offering is in the 150 to 250 basis point range. This is in excess of where the credit curve has historically been and significantly wider than the spread between 5 and 30 year US Treasuries. The table below has a few examples of the yield difference between investment grade corporates at various points along the yield curve.

Issuer Ratings 2 Yr Yield 5 Yr Yield 10 Yr Yield 30 Yr Yield
US Treasury Aaa/AA+ 0.58 0.94 1.37 2.14
Halliburton Corp. Baa1/A- 1.44 2.32 3.13 4.23
Verizon Wireless Baa1/BBB+ 1.26 1.89 2.35 4.05
Hewlett Packard Enterprises Baa2/BBB 1.7 2.96 4.09 6.11
Dell (Diamond 1 Finance) Baa3/BBB- 2.51 3.67 5.27 7.57

What these spreads suggest is that investors seeking income as well as total return should consider a barbell approach to bond investing as opposed to the traditional ladder approach. For example, a portfolio with a 5 year duration could be a combination of 2-7 year maturities or a combination 2, 10, and 30 year bonds that would produce more yield with similar interest rate risk. The advantages of this portfolio are simple: greater cash flow and better returns, regardless of whether the yield curve keeps its existing shape or continues to narrow. This profitable little package is referred to as the deflationary scenario.