While Treasury yields bounced a bit in Q3, the longer-term trend has clearly been down. Chart 1 shows the very well defined declining range of Treasury yields over the last 20 years. Yields currently sit near the bottom of the long-term trading range and very near generational lows.
With the Federal Reserve's intent upon keeping long- and short-term yields low through quantitative easing, it seems unlikely that there is an imminent risk of rising yields. Robust economic growth and/or inflation seem like the most likely candidates to push rates higher in the future. We are not there yet.
Chart 2 shows that the yield decline hasn't only been in the Treasury market. Corporate bond yields (e.g., Moody's Aaa and Baa) as well as T-bill yields also sit near generational lows. Chart 3, however, suggests that there may still be some value left in the credit markets. While we don't necessarily see credit as cheap, the yield compared to Treasuries (i.e., the spread) is still fairly elevated.
Absolute yields of about 3.5% for Aaa and 4.85% for Baa rated papers aren't attractive on the surface, but with spreads on both credit qualities trading at 91 bps and 128 bps respectively over their historical averages (as of 9/30/12), a case can be made that credit still offers some value on a relative basis.
Think of this another way. Bond investors have two main risk exposures that they can expose themselves to: duration risk or credit risk. Since positive real-yield is pretty much non-existent in the Treasury world, we clearly believe that the better risk/reward trade off is offered by credit.
The risk/reward for Treasury duration is not a good setup, in my opinion. Consider the following example. What if interest rates on the 10-year Treasury go down by 1% in one year's time to about 0.80%? This would be well below the yield offered on the 10-year Japanese Government Bond. A move that low would likely be spurred by severe economic weakness. It's very hard for me to believe we would sustain a yield on our 10-year Treasury below that of its Japanese counterpart, which has been grappling with on-again, off-again deflation for about 20 years. Bear with me, though, for the sake of example.
With today's yield of about 1.80% and a duration of about 9, a 1% decline in yield would produce an upside of just under 11% (1.8% yield + 9% price increase). If yields go the other way by 1% - more likely in my mind - the loss would be about 7% (-9% in price + 1.8% interest). If yields move up by more than 1%, the losses compound. A test of the upper trendline near 4% (Chart 1) would net a price decline of around 20%.
Corporate balance sheets have been rebuilt over the last few years, and default rates remain low. Though it is not cheap in absolute terms, we clearly favor credit. For the more risk averse, we favor iShares iBoxx $ Invest Grade Corp Bond (NYSEARCA:LQD) and PIMCO Low Duration D (MUTF:PLDDX). For those willing to take on a bit more credit risk to seek higher yields while mostly avoiding duration risk, PowerShares Senior Loan Portfolio ETF (NYSEARCA:BKLN), Fidelity Floating Rate High Income (MUTF:FFRHX) and Lord Abbett Short Duration Income (MUTF:LALDX) could be worth a look. Nearing the top of the risk spectrum is high yield. For those willing to take on equity-like risk for a portion of their bond holdings, I think it makes sense to "cheat" up the quality scale a bit at this point in the cycle. PowerShares Fundamental High Yield Corp Bond (NYSEARCA:PHB) and Wells Fargo Advantage High Income (MUTF:STHYX) tend to do just that.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.
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