Bond yields can be a real head-scratcher for investors. Rising yields are a function of falling prices; falling prices usually mean an asset is out of favour, yet higher bond yields signal better returns for those who buy at less than par value. So what is behind the recent surge in yields – particularly in the US Treasury market – and are bonds a good or a bad investment in the current environment?
US 10-year Treasury yields are currently close to their highest level in over 15 years – a period that goes back to before the global financial crisis, effectively negating the entire post-GFC era of ultra-low interest rates and quantitative easing. At the same time, the yield curve remains inverted, with higher yields on short versus long-dated bonds, something that is often seen as signalling a recession.
However, Iain Stealey, CIO of global fixed income, currency and commodities at JP Morgan Asset Management, explains that the recent spike in yields is principally due to the US economy looking better than feared, rather than worse.
“A lot of people had thought the US would see a recession this year, but that is now less and less likely,” he says. “So what we are now seeing is not so much a repricing of terminal bond yields [i.e. where they will end up], but a pricing out of Fed rate cuts – from initial expectations of a cut this year, the first cut is now not expected until next year.”
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Indeed, speaking at the conclusion of last week’s annual retreat at Jackson Hole, Wyoming, Federal Reserve chair Jerome Powell refused to rule out further interest rate increases, noting that the committee intends “to hold policy at a restrictive level until we are confident that inflation is moving sustainably down toward our objective”.
Jean-Yves Chereau, partner at J. Stern, underlines this growing realisation that “it is not going to be as simple as people thought to get inflation back to target”, adding that while core inflation in the US is moving in the right direction, it remains higher than hoped. He sees this as a key factor in the rise in yields, although oversupply and thin trading volumes – late summer is rarely a good time for market liquidity – are a further, technical reason for falling bond prices.
“In the US, because of the debt ceiling being raised and the need for government funding, there has been huge supply of Treasuries – and we are seeing the same with UK gilts – and that is creating a vacuum up in yields, especially in a thin market as it is now,” he says.
Stealey highlights another technical factor in the form of a recent monetary policy tweak from the Bank of Japan. “The Japanese are big buyers of Treasuries, but if they can get yield at home, they don’t need to go to the US for it,” he explains.
Chereau is less surprised by the recent spike in bond yields than he is by how long it took to happen. “We have been saying all year that 10-year Treasury yields should be at the level they are now,” he comments, explaining that prior to the GFC, when inflation was lower than now but was more in line with central bank targets, 10-year yields were in their current range of 3.5-5%. “It is going back to normal after 14 years of zero interest rates and yields – so there is a new paradigm, but it is really the old paradigm,” he says.
Both managers have been taking advantage of the higher ‘risk-free’ rates available in the current environment. In J. Stern’s multi-asset income strategy, Chereau and colleagues have been gradually cutting equity exposure, which was increased in the stock market correction of Q4 2022, and increasing the allocation to fixed income.
“We have been taking profits in equities as the market carried on going up, and now we are conservatively positioned at the lower end of our 35-55% equity exposure range,” he says. “An interesting part of the new paradigm is that you can buy risk-free government bonds in the US and UK and be paid 5.5%. Three years ago, if you were buying emerging market debt, in the quality zone you would make 5%, and now you don’t have to take any risk to get that.”
Outside of the long-dated government space, yields are even more attractive, Chereau adds: “You are spoilt for choice in the current market. Because of the correction in bond prices, you can now easily buy 11-12% yields to maturity on four years’ duration. New issues that are coming to market in high yield and investment grade are adjusting to the new paradigm, but the secondary market is also offering higher yields on quality bonds with equivalent returns.”
In the JPM Unconstrained Bond Fund, the increase in yields has enabled Stealey to position the portfolio on a lower-risk footing. “We have been reducing high yield risk to buy investment grade credit, removing our short position in government bonds and rotating up in quality,” he says.
“The lagged impact of monetary policy will bite at some point. We had underappreciated the strength of the US consumer, but 550bp of hikes is going to have an impact, so we have been conservative. Quality bonds give a good yield and there is potential [capital] upside if central banks need to start easing policy.”
