The U.S. Federal Reserve (Fed) has been monopolizing the headlines over the past few years, with the investment industry analyzing, critiquing and scrutinizing every statement and forecasting every movement, as they unwind their accommodative monetary policy and zero in on reducing their bloated balance sheet.
Investors should have a keen interest in the direction and trajectory of interest rates if they want to know what’s going to happen to their fixed income assets, and that means understanding and interpreting the shape of the Treasury yield curve. The curve can help financial advisors leverage different fixed income sectors to produce enough income for their clients.
The Treasury yield curve is displayed as a line on an x-y graph, with interest rates on the y-axis, and the amount of time until a Treasury bond matures on the x-axis. The curve displays the spread between short-term and long-term rates. Typically, the yield curve is upward sloping, as investors require additional compensation for investing in long-term bonds that bear additional long-term risks.
In figure 1, we can see the yield curve as of June 30 (red line). Even though the line is upward sloping, the interest rate spread between the two-year Treasury note (1.38%) and the benchmark 10-year Treasury bond (2.31%) is narrow. The same conclusion can be drawn based on the five-year and 30-year spread. To provide some perspective, we have also included the yield curve from March 30 (blue line). As you can see, the March 30 yield curve steepens from 1.28% for 2-year notes to 2.42% for 10-year Treasuries.
As I mentioned prior, investors expect to be compensated for investing longer on the yield curve. However, when the yield curve flattens, the reward investors receive for investing in longer-term debt shrinks.
Understanding what determines the shape of the curve is a little more complex. The short end of the curve is directly impacted by the Fed’s interest rate polices, hence the low interest rates for short maturities since the credit crisis. Conversely, yields on long-term bonds are dependent on market forces such as supply and demand, investor sentiment, inflation, and macroeconomic forces.
As of June 30, the spread between the two-year Treasury note and the benchmark 10-year Treasury bond was .93%, compared with three months earlier, when the spread was 1.13%. From a historical perspective, spreads haven’t been this narrow since the credit crisis, and since 1990 the historical average spread has been 1.24% (orange line). One can see how a shift in the yield curve can affect fixed income investors.
This shrinking spread is a result of rising short-term yields due to the Fed increasing the federal-funds rate, while long-term yields have been declining due to suppressed inflation, fiscal policy uncertainty, and some recently disappointing economic data.
Foreign demand for U.S Treasuries is also weighing on long-term yields. While long-term yields may appear low to U.S. investors, international investors are jumping at the opportunity to invest in U.S. Treasuries that offer safety along with an attractive yield compared with what they can get at home, which in some cases are either zero or negative. These market forces are pushing long-term yields lower, resulting in a shrinking yield spread.
For advisors trying to build fixed income portfolios that provide needed income for clients, while also minimizing risk, long-term Treasuries may not be the place to go. There are other fixed income products that can help provide income without compromising the risk profile of the portfolio.
Look at the performance, risk and correlations of the various fixed income sectors versus the Citigroup 10-year Treasury Benchmark over the past 10 years.
Municipals (Bloomberg Barclays Municipal Bond) have provided investors with tax-free income, reduced risk and low correlation compared with the Citigroup 10-Year Treasury Benchmark. If your client can afford to stomach additional risk, high-yield (BofA Merrill Lynch US High Yield) and emerging-market debt (BofA Merrill Lynch US Dollar Emerging Markets Sovereign Plus) provide investors with enhanced total return, income and diversification.
Going shorter on the yield curve also provides a good opportunity for investors looking to shorten their duration. Represented by the BofA Merrill Lynch 3-5 Year US Corporate Index, corporate debt maturing in 3 to 5 years has provided investors with a respectable total return of 4.83 percent, with an effective yield of 2.58 percent, in addition to reduced risk and low correlation compared with the Citigroup 10-Year Treasury Benchmark.
History typically repeats itself, and this isn’t the first time that the yield curve has flattened going into and during a hiking cycle; however, every cycle is different. Diversification, such as building a bond ladder, can help reduce the effects of a shifting yield curve and help keep your clients on track to achieving their goals.
Ryan Nauman is a vice president, product and market strategist at Informa Financial Intelligence. His market analysis and commentaries are available at informais.com/blog.