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Treasury Yields De-Coupling From Other Bonds

|Includes:HYD, HYG, IEF, LQD, SHY, iShares 20+ Year Treasury Bond ETF (TLT)

I just updated the tables of yield vs. risk on the Yield Frontier page. As part of an ongoing discussion of the frontier of yield vs. risk, I will first examine the bond asset classes--and they are very interesting. The results are shown below.

What is most evident is that the different types of bonds (each represented by an ETF) show a consistent relationship between yield (vertical axis) and expected volatility (horizontal axis). The two exceptions to this relationship are intermediate and long-term Treasury bonds, which are providing very low yields as compared to their risk levels.

These results tell an important story. The risk in bonds comes from two sources: inflation and default. Treasury bonds are assumed to have no default risk, so all of the risk is inflation risk. The various types of corporate and municipal bonds have varying balances of default risk vs. inflation risk. The very low yields on intermediate and long Treasury bonds tells us that investors are willing to accept less compensation (lower yield) for bearing inflation risk than for default risk. This decoupling has been partly driven by the U.S. government's purchasing of its own bonds as part of QE--the Fed is buying Treasury bonds to provide stimulus rather than in hopes of returns. Treasury bonds have essentially decoupled from other bond classes.

High-yield corporate bonds and high-yield muni bonds have high yields relative to their risk levels, but these are part of a consistent tradeoff between yield and risk as compared to other fixed income classes. This is, in itself, somewhat intriguing given that there are reasons why high-yield bonds should behave somewhat differently than other higher-rated bonds classes. Many pension plans, insurance companies, and other institutional investors are prohibited from owning these asset classes because they are considered to be below investment grade.