Low-Yielding Debt and the Vanishing Yield Cushion

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As has been obvious to see, the recent COVID-19 pandemic and the resulting stimulus from Central Banks worldwide has sent the bond market into frenzy. The extra liquidity from QE efforts has suppressed both government and corporate bond yields and forced investors to venture into the riskier areas of the credit market. Approximately 85% of bonds worldwide now yield less than 2%, with the amount of negative yielding debt taking up roughly 25% of the global bond market. With Treasury yields hovering near the zero bound, the so-called yield cushion that has historically protected investors from falling interest rates is diminishing.

Declining sovereign yields has led to the rise of negative-yielding investment grade debt. Source: Bloomberg

To understand how the bond market is changing, it is important to first know how bond returns are derived. Obviously, there are many risk premia attached to bonds (liquidity, prepayment etc) but the main two are duration (interest rate) and credit risk. The yield cushion gets its name from the inverse relationship between bond prices and yields, leading to capital gains on bonds in falling interest rate environments. Thus, the duration exposure inherent in bonds ‘cushions’ the negative effect of falling yields. Preceding the financial crash of 2008-9, the Federal Funds rate was high at 5.25%, meaning the expansionary rate cuts that followed were met with ample room for bond price appreciation. This feature acted as a quasi-hedge against the gargantuan equity drawdowns during this time, as investors were well compensated for the falling interest rates.

However, the gradual movement of rates towards the lower bound through 2019 means the story is different today. With interest rates at 1.75% in October 2019, there was much less room for rates manoeuvre when the pandemic hit. Lower starting yields has meant that the bond price appreciation seen in the last financial crisis is much less applicable today. Moving forward, this is unlikely to change as capital returns will be unable to offset increasingly present negative real yields.

Bonds no longer provide the same level of returns during equity bear markets. Source: Ardea Investment Management

The zero-interest rate environment will likely shift how investors approach duration-based investments. As expected from the higher duration exposure, longer dated Treasuries were some of the best performers in March, with the S&P U.S. Current 30-Year Treasury Bond Index yielding a monthly total of 7.68%. But with the 30-year Treasury yield at around 1.42%, investors may begin to question this reward for the inherent duration risk in these bonds. In the short term, inflationary pressure is unlikely to be seen due to historically low monetary velocity, as measured by the ratio of nominal GDP to money supply. But the Fed’s decision to adopt average inflation targeting during Thursday’s Jackson Hole Symposium warned of higher inflation and long-ended rates down the line, causing the 10-year and 30-year Treasury yields to shoot up 5.8bps and 9.3bps respectively. This downwards pressure on longer dated Treasury prices is only the start of a dreary period for bond investors. With the Fed likely to keep short term rates low for a sustained period, 2s10s and 5s10s bear steepener trades have been, and will likely continue to be, profitable.

Central Bank intervention has caused the front end of the Treasury Yield Curve to hover near 0%. Source: GuruFocus

The second implication is the changing composition of bond returns. As the interest rate component of bonds decreases, a larger proportion is made up of credit risk. Instead of being related to the broader macroeconomy, a larger credit risk component naturally places a larger emphasis on the performance of specific companies. So far, U.S. equity markets have recovered strongly from the COVID-19 crisis, with the S&P 500 reaching 3,374 to surpass late February’s highs (19 Aug). But this higher correlation with equities markets could prove costly if corporate bankruptcies continue to rise and equity markets experience a drawdown. Whilst the latter is unlikely at the current moment, consider potential hedges with CDX indexes or simply reducing exposure to credit below investment grade status.


References

  1. Colby Smith, “Desperate hunt for yield forces investors to take ‘extreme risk’”, Financial Times (July 2020), https://www.ft.com/content/b44281c0-2ddb-46ae-83e2-150461faed65
  2. Ardea Investment Management, “Low yields increase the equity beta of credit investments”, https://www.ardea.com.au/low-yields-increase-the-equity-beta-of-credit-investments/
  3. Ardea Investment Management, “Vanishing yield cushions and the asymmetry of duration risk”, https://www.ardea.com.au/the-asymmetry-of-interest-rate-duration-risk/
  4. GuruFocus, Treasury Yield Curve (2020), https://www.gurufocus.com/yield_curve.php
  5. John Ainger & Tasos Vossos, “World’s Rising Stock of Sub-Zero Debt Has Investors Adding Risk”, Bloomberg (July 2020), https://www.bloomberg.com/news/articles/2020-07-27/world-s-stock-of-negative-yield-debt-climbs-toward-2019-s-record
  6. Sunny Oh, “10-year Treasury yield nears 0.75% after Fed says it will aim for 2% average inflation”, MarketWatch (August 2020), https://www.marketwatch.com/story/treasury-yields-hold-steady-before-fed-policy-review-2020-08-27
  7. Wilbanks Smith & Thomas, “March 2020: Fixed Income Market Review”, https://www.wstam.com/news/market-updates/march-2020-fixed-income-market-review/

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