Salman Ahmed, chief investment strategist at Lombard Odier Investment Managers, notes during the recent episode of investor risk aversion the behaviour of US treasuries has been “interesting”.
He says typically in an environment of higher risk aversion and an equity sell-off, there is an increased demand for both the US dollar and US treasuries, resulting in price gains, but in the current sell-off the dollar has remained stable while 10-year treasury yields have been mostly stable since February.
“[Treasuries have] only declined by about 10 basis points (bps) over the past week. This is a small drop compared to the decline of about 30bps in bunds, gilts, Canadian and Australian bonds since mid-February,” he says.
“This suggests that some of the factors that have pushed the US dollar lower and caused US treasury yields to drift higher are likely to still be at play. The implication is that foreigners’ demand for these assets remains weak, in part driven by the political uncertainty and the cost of hedging.”
Ahmed says the muted reaction of the dollar and treasuries could have an impact on investors who rely on these historical relationships to hedge their portfolio; in the past, falling yields and rising bond prices partly compensated investors at times of falling equity markets.
Better value, higher yield, low risk
Mike Coop, head of multi-asset portfolio management at Morningstar Investment Management, says on a global view US government bonds look attractive compared with most other markets because they are yielding a positive real return.
“In the UK there is a lot more debt issued in much longer dated bonds and the level of yield is lower,” he says. “When the yield is lower the duration is longer because basically a 1% increase in yield has more of an impact than when your starting yield is 0.5% rather than 5%.
“US government bonds look better value, offer more yield and are less risky.”
The government debt also stands out among global bond markets because credit spreads are tight making corporate debt not particularly attractive.
They are also extremely reliable, adds Coop.
“The role of bonds in a multi-asset portfolio is to diversify equity risk, so the bad scenario for equities is where corporate earnings fall and in that environment you get downward pressure on prices and government bonds are always going to pay you the coupon no matter what.
“That certainty of being paid back in inflation-adjusted terms it becomes more valuable. US government bonds are very effective at playing this role.”
Watching brief
Neil Birrell, chief investment officer at Premier Asset Management, agrees there is a solid investment case to be made for US treasuries because they are yielding more than their sovereign counterparts.
Premier does not have any traditional fixed income exposure in the Premier Diverisified fund, nor the Premier Diversified Income fund, because despite the recent sell-off, the firm still does not believe bonds offer an attractive risk/reward profile.
He says: “We just don’t think you are getting paid for the risk. If you are going to buy 10-year gilts at 1.5% that is not attractive in any event. The German bund at 0.65% is not really attractive. Maybe if you get 10-year treasuries at 3% you could argue on a safe-haven basis there is some value to be had.”
Birrell is therefore watching yields closely from the sidelines, but is cautious of a potential upward surprise in interest rates in the US, driven by strong GDP growth and/or inflation being higher than expected.
Julian Chillingworth, chief investment officer at Rathbones, says US treasuries are attractive at current levels and predicts yields will move out further to 3-3.25% – but that is already priced in.
“In the next 12 months we are going to see rising rates in the States as the Fed unwinds its QE policy and beings to normalise rates. That to a degree is already reflected in the 10-year bond yield but we can see it moving to around 3-3.25% but that is against a robust picture for the US economy.”
Chllingworth says: “If yields are rising because growth is stronger it means company earnings should come through stronger, which should be good news for good quality equities and companies with good business models.”
“If you are in a high inflation environment and trying to choke off high inflation by pushing interest rates up that may well have more of a negative effect on equity markets but we are not in that situation. We are in a situation where growth is good so consequently you should see earnings continue to come through strongly and valuations don’t look stretched.”
Trade war
One thing Birrell is wary over is the impact of a potential Chinese sell-off in US treasuries, which would cause yields to spike.
Market watchers have expressed concern that China could reduce its treasury purchases in response to Donald Trump’s trade tariffs, which would send interest rates soaring and yields sky high.
China is the largest foreign holder of US debt and, according to the US Department of the Treasury, owned £1.17trn of treasuries at the end of January.
This could be China’s not-so-secret weapon against the US in the trade war.
But Coop believes this is not an issue, saying it is “idle speculation” to forecast what course of action the large holders of US debt like China are going to take.
He believes such a sell-off, were it to happen, would be a “tectonic-type change” rather than a rapid rush for the exit.
He adds: “You have seen the Chinese authorities clearly have a desire to establish their currency and bond and equity markets to be a major part of the global capital markets but these things take a long time so there are relatively few alternatives to US government bonds.
“The simple fact is US government bonds are one of the largest most liquid markets in the world and if you have a large amount of money, there are not many other places you could put your money.”
