On the day I joined the financial services industry in 1983, 10-year U.S. Treasury notes yielded just over 11%. During my career they peaked at 14%. (The actual high point of 15 .75% occurred in 1981.) But despite some sharp reversals along the way, yields continued to decline until they reached a historic low-just above 2%-at the end of 2008. With the Federal Reserve's asset purchase program now holding Treasuries at their average level since the 2008 crisis point-and the U.S. economy on a sustainable growth path-the almost 30-year rally in Treasuries appears to be over. Now, investors reasonably ask whether fixed income investments actually have a future. My answer is that they do. But to participate, investors will increasingly need to globalize their thinking and consider opportunities beyond the supposed "risk free" haven of U.S. sovereign debt.
Investors have accepted the very low yields U.S. Treasuries offer because they have become global investors' financial fire insurance policy. However, a thoughtfully sized allocation to high quality bonds can help temper portfolio performance at times of market stress. The problem is that an overly large allocation can also temper appreciation when markets turn up, especially since a strengthening economy and improving returns from riskier assets will tend to push Treasury yields up and prices down.
Very low interest rates do not necessarily have to rise. The Japanese 10-year government bond (JGB) yields, for example, fell below 2% in late 1997 and, except for a few weeks, have stayed below that level for over 13 years. But could U.S. Treasuries follow a similar path?
Japan's chronic economic woes began with an asset bubble collapse that undermined the financial system and saddled banks with vastly overvalued assets. The U.S. housing bubble and financial crisis sound strikingly similar. Could those similarities keep Treasury yields in the same low-for-long range that JGBs have endured? Doubtful. The U.S. policy response dwarfs the Japanese equivalent.
The Federal Reserve Bank began creating money to buy financial assets as an immediate response to the financial failures of late 2008 and has expanded the program over two years. The Bank of Japan launched an equivalent, but much smaller program a decade after its bubble burst.
Treasury yields have risen since the most recent bout of European sovereign debt angst, and will likely rise further as the economy expands and inflation expectations supersede deflation fears. Timing the path of rates remains uncertain, and a trudging economic expansion with quiescent inflation means that Volker-era yields are not in our foreseeable future. In this economic environment, fixed-income investors should consider how bonds, beyond Treasuries, may be able to enhance portfolio returns.
Leaping to High Yield
Start with higher yielding corporate loans and bonds. A market index of high yield bonds currently pays a premium or spread of about 5.5% over Treasury yields. A similar index of leveraged corporate loans pays about a 5% premium. While these yields are far below the nearly 18% spreads reached near the end of 2008, they are still above the 3.75% level that we consider fully valued. The leap from the apparent safety of Treasury bonds to the high yield market may seem aggressive, but there are several factors work in high yield investors' favor. Given the slowly growing economy, Moody's Investor Service expects high yield defaults to range between 2% and 2.5% during 2011 and 2012, down from the 10.30% level in 2008. During 2010, high yield companies issued $286.7 billion in bonds. A large portion of proceeds were used to extend debt maturities to 2015 and beyond.
This debt extension is important for investors because companies tend not to default in meeting regular coupon payments but default in paying off principal when it comes due. Finally, the subsector of the high yield market composed of levered bank loans carries the additional advantage of interest rates that adjust with the current market thereby giving investors some protection, even benefit, from rising interest rates.
Reconsidering investment sectors that initially appear distasteful often serves investors well. Packages of residential and commercial mortgages without government guarantees-private-label mortgage-backed securities (MBS)-might fit this description. While segments and regions of U.S. and some foreign real estate markets remain overbuilt and economically fragile, the market has tended to treat the entire sector as a victim of the bubble and ensuing financial crisis. In fact we believe that well-structured, properly underwritten securities do exist and might be available at reasonable prices and attractive yields. The problem is the work to find and analyze the appropriate structures. This lunch isn't free, but it might just hit the spot.
Munis: Down But Not Out
Municipal bonds are a more familiar but recently very unpopular sector of the bond market. States and municipalities continue to face serious annual budgetary shortfalls and huge commitments to employee and retired employee benefits. But exaggerated, unsubstantiated forecasts of massive defaults ignore the history, incentives and financial progress of municipal issuers. Municipal defaults actually declined in 2010 and should remain at low levels as tax revenues recover and expenses are slashed. Municipal bonds, especially those dependent on revenue from speculative or uneconomic projects, will default from time to time, and investors should carefully analyze bonds they buy. But, when the highest quality long-term munis offer yields in excess of comparable duration Treasury bonds, it's time to take note. Investors able to evaluate municipal credits case-by-case might consider looking beyond the highest-rated munis, as the yield premium for taking on credit risk is above its historical average.
A final category of yield-seeking fixed income is the local-currency sovereign debt of emerging markets. It has been gaining rather than losing investor attention, and for good reasons. After recovering from the financial crises that occurred 10 to 15 years ago, many emerging countries strengthened their fiscal and monetary policy regimes, loosened the reins on business, and now find themselves in much stronger budgetary shape than supposedly "safer" credits like Western Europe, the U.S., and Japan. Add rapid economic growth, improving efficiency and a young population, and the emerging economies offer attractive long-term investment opportunities for equity and fixed income investors. Appreciating currencies and yield above Treasury yields have heightened attention to emerging market bonds. A word of caution, however: Just as adversity can lead to attractive pricing, popularity can lead to steep prices. With certain major emerging countries attempting to slow growth and restrain foreign investment flows, investors should carefully balance the long-term attractiveness with near-term market conditions.
Those of us who have been watching fixed income markets for many years can recall times when U.S. Treasury bonds offered high yields and opportunities for capital gains as those yields fell. Those times are past and will return only if a series of policy errors creates persistent and troubling inflation. Treasuries have served an important function by historically outperforming securities such as equities and credit-sensitive bonds in times of fiscal, economic or financial trouble. Treasuries, therefore, deserve an allocation in most of our portfolios. In today's environment of recovering or expanding global economic growth and the potential for modest asset appreciation, fixed income investments that contain risks that Treasuries avoid have the potential to provide better total return opportunities and can be a source of wealth accumulation as cash flow is used to buy more cash flow and the power of compound interest shows its potential.
Dr. Jerry Webman, Ph.D., CFA, serves as the
Chief Economist at OppenheimerFunds, Inc.
in New York. In this capacity, Dr. Webman provides
strategic viewpoints on the overall financial and
economic markets to the investment management
and the financial advisor and investor communities.
He can be reached at: this email address.
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