Chas Craig, BridgeTower Media Newswires
Many investors are reconsidering the appropriateness of bonds in their portfolios since the space, as measured by the Bloomberg US Aggregate Bond Index (AGG), has returned -10% year to date, scantly besting the -12% result for the S&P 500. This sort of decline over such a short period is normal for stocks, not so for bonds.
All investors have a unique set of risk and return objectives that inform their proper asset allocation. However, today we make the case for bonds generally through the lens of arguably the most important interest rate in the world, that on the 10-year U.S. Treasury Note. Part I focuses on long-term inflation expectations; the real yield component, which is the portion of a nominal yield over and above (or sometimes below) inflation is the subject of Part II.
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Part I: Long-term inflation expectations
The 10-year Treasury Note started the year at 1.5%, near the prevailing level at the time of the inaugural column in this space nearly six years ago entitled “Sovereign Bond Yields & Greater Fools.” It now rests just below 3%, the high-water mark for the past decade. A 3% 10-year is not terribly surprising, but the speed in getting here has been. As a result, bonds have not provided the cushion they typically have to a stock-heavy portfolio during an equity market downdraft. Since bond yields and bond prices move inversely, many investors are seeing meaningful amounts of red in their bond portfolios for the first time.
Now, some might say here, “Yeah, OK, but annual inflation is currently in the high-single-digits, so real yields are still deeply negative and make bonds a still bad investment.” True, if inflation remains anywhere near the levels at which it is running now, bonds are a terrible investment. However, as expressed verbally and in writing last month for The Journal Record, while acknowledging significant uncertainty and the distinct possibility I could be completely wrong, my current point of view is that inflation will come back to a range of something like 2% to 3% over the next couple of years. I should also point out that if I’m wrong about the “soft landing” aspect and the economy slips into recession, it seems reasonable to think that would be disinflationary and, therefore, bullish for high-credit-quality, intermediate maturity bond allocations like that represented by AGG, all else equal.
Importantly, the market for Treasury Inflation Protected Securities is currently in agreement. The difference in yield between nominal and inflation protected Treasury Notes (i.e., the breakeven rate) is a market-based measurement of inflation expectations. The current 2-year breakeven is 4.28%, and the current 10-year breakeven is 2.85%. The algebraic implication for years 3-10 is that the market is pricing in an average inflation rate of 2.5%, or smack in the middle of the 2% to 3% range that I expect will characterize “normal” for the foreseeable future once the “transitory” factors (hopefully) fade from the inflation picture over the next couple of years.
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Part II: Real yield
So, assuming this point of view on inflation is correct which, of course, it might not be, what does it imply for the fair value yield on a standard, nominal 10-year Treasury? To answer that question, one also requires a viewpoint on the real yield component, which is the portion of a nominal yield over and above (or sometimes below) inflation. In looking at a historical graph (https://fred.stlouisfed.org/series/DFII10) of real yields for 10-year Treasury Inflation Protected Securities, one makes a few observations.
First, real yields have been suppressed since the Global Financial Crisis (GFC), and the burden of proof resides with the camp arguing in favor of higher prospective real yields in this case. Next, the 2013 spike in real yields from -0.7% in April to 0.9% in September was associated with the “Taper Tantrum.” This was the last time the Fed signaled it would move off extraordinarily loose monetary policy and probably offers the closest analog to what we’re living through now. Also, excluding the two extraordinary periods (i.e., Covid and the GFC aftermath) when the Fed was engaging in quantitative easing (i.e., buying bonds) with no publicly stated plan to wind down those operations, the “normal” level for real yields in the post-GFC period has been about 0.5%.
So, tacking on a 0.5% normal real yield to my 2.5% normal inflation rate assumption implies a fair value yield on the nominal 10-year Treasury of 3%, effectively where it is now. Of course, even if this analysis proves correct, one can’t expect it to just go to 3% and stay there. But just like how the range for the 10-year has been 1% to 3% over the post-GFC period, I expect it is most likely to range between 2% and 4% for the foreseeable future. In short, the bulk of the move higher in rates and down in price for bonds has probably already happened.
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Chas Craig is president of Meliora Capital in Tulsa (www.melcapital.com).
