The world can be a confusing place for fixed-income investors, what with negative interest rates and continuing asset purchases by global central banks. In fact, we’ve noticed four common misperceptions on bond investing today that just don’t hold up under close scrutiny. They include the idea that tapering will inevitably lead to higher U.S. Treasury yields, and that investors should look to dividends for income rather than bonds.
Four false bond narratives
When it comes to fixed-income investing, we certainly believe there are some helpful rules of thumb based on sound data and analysis. However, there are other fixed-income narratives that, if anchored to, could potentially hurt or limit investors’ returns. Here are four common misperceptions that stand out today:
1 The U.S. Federal Reserve (Fed) is going to raise rates, so I should position with shorter duration strategies.
2 Tapering quantitative easing (QE) purchases will result in rising longer-dated Treasury yields.
3 Investors should use the equity market for income instead of the bond market.
4 Greater supply of Treasuries means higher Treasury yields.
Myth 1: the Fed is going to raise rates, so I should position with shorter duration strategies
After recessionary periods, this is often the mantra. The perception is that in early and midcycle environments (the first two phases after a recession), the 10-year Treasury yield will persistently rise on the back of an improving economy and rising inflation. The initial postrecessionary backup in yields has, in fact, been short-lived. Over the past 40 years covering four economic cycles, the 10-year Treasury yield has found its highest level of the cycle within a year after the recession. After peaking, it then fluctuates in a trading range, ultimately finding a new lower low in the subsequent recession.
10-year U.S. Treasury yields (%) and recessions
Source: FactSet, as of 8/31/21. Shaded areas indicate recessions.
In examining Morningstar category returns data in the last two cycles, we’ve found that short duration strategies have been the worst relative performers in midcycle periods.¹ Meanwhile, the best performers have been in corporate bond markets such as high-yield bonds. The logic behind the performance differential is that the shorter duration strategies offer lower income, providing less return potential. While corporate bonds do have longer duration, they don’t typically see much of a duration headwind to returns as longer-dated Treasury bond yields typically stay more anchored than expected. Investors instead benefit from a roll down from being further out on the curve, helping with return potential.
This means that overemphasizing short duration strategies in fixed-income portfolios may leave returns on the table. Instead, we’d look to a corporate credit bias to earn greater income in the middle of the cycle with a more intermediate-term target for duration.
Myth 2: tapering QE purchases will result in higher longer-dated Treasury yields
This logic seems sound: With the Fed buying fewer government bonds, demand should fall while supply (all else equal) remains constant, pushing up yields. In fact, tapering, or halting, bond purchases in the past has had a rather counterintuitive response from the bond market. The end of QE2 in 2011 and the tapering of QE3 in 2014 are the past periods when tapering of one form or another occurred. In these periods, the 10-year Treasury yield fell from 3.00% in June 2011 to 1.47% in July 2012, and then from 2.97% in January 2014 to 1.65% in January 2015.
A potential explanation for this is that when the Fed does QE, it’s considered extremely easy monetary policy, which spurs a market reaction of selling longer-dated Treasuries for higher risk/return assets. When the Fed is tapering, it’s signaling less easy monetary policy and the market responds to that with less risk taking—causing the curve to flatten and putting downward pressure on the 10-year Treasury yield.
When the Fed’s balance sheet has leveled off, U.S. Treasury yields have declined
Source: FactSet, as of 7/31/21. Quantitative easing (QE) is a monetary policy in which a central bank purchases government debt or other fixed-income securities in an effort to lower interest rates, increase the money supply, and stimulate economic growth. Past performance does not guarantee future results.
Myth 3: investors should use the equity market for income instead of the bond market
This is another narrative that seems to make sense, at least on the surface: The yield on the Bloomberg U.S. Aggregate Bond Index (Agg) sits near historic lows at 1.43%, limiting income potential. This could make the dividend yield found in equities appear more attractive on a relative basis. Unfortunately, the dividend yield on the S&P 500 Index is currently 1.27%, less than the yield on the Agg. In addition, equities come with more risk than bonds, with the S&P 500 Index sporting a 3-year standard deviation of 18.07% versus 5.43% for the Agg. Don’t get us wrong: We still think equities play a critical role in a portfolio—namely, capital appreciation. Bonds play the other critical role: generating dependable returns and providing a cushion in periods of equity market volatility.
Yield and volatility of U.S. stocks and bonds
Source: FactSet, as of 8/31/21. It is not possible to invest directly in an index. Past performance does not guarantee future results.
Myth 4: greater supply of Treasuries means higher Treasury yields
Another common belief is that given the massive deficit-funded stimulus packages of 2020 and into 2021, Treasury yields should be higher. The inner workings of supply and demand do typically drive asset prices. However, in the U.S. Treasury market, the connection between supply and the resulting price/yield level has been virtually nonexistent for decades. In 2020, Treasury bond issuance rose 32.7% year over year, or $3.9 trillion, which caused the overall Treasury debt outstanding to reach an unprecedented $22 trillion. In the wake of this massive issuance, the 10-year Treasury yield fell from 1.92% to 0.92%.
While this is counterintuitive, we usually see Treasury issuance spike amid recessionary environments. This makes sense, as stimulus is usually driven from countercyclical policy moves designed to jump start the economy. In these periods, demand for Treasuries is typically strong as investors look to the safety of higher-quality assets. From a longer-term perspective, Treasury yields have been falling for the last 40 years while the amount of Treasury debt outstanding has increased substantially. We would not let the supply of debt meaningfully alter fixed-income positioning as it has shown to have a minimal if any impact on Treasury yields over time.
U.S. Treasury yields and Treasury debt outstanding
Source: Federal Reserve Bank of St. Louis, as of 7/31/21.
Data over narratives
Making asset allocation decisions within fixed-income portfolios can easily lead to an overreliance on widely held beliefs, or myths. We’ve found that challenging these misperceptions by using data and analysis has enabled us to make better decisions in Market Intelligence.
Relying on input from our experienced bench of fixed-income portfolio managers has also helped. Their intimate understanding of the dynamics of the bond market over time has resulted in a unique perspective that often challenges current thinking. When it comes to the dynamics playing out in today’s bond market—whether it’s potential changes to Fed policy, elevated Treasury supply, or low return potential arguing for a better alternative—investors may be well served to rethink the prevailing narrative.
1 “Midcycle investing: a guide to portfolio construction,” John Hancock Investment Management, June 2021.