Fixed income investors have options to increase returns, lower risk
As all investors are aware, fixed income yields and overall returns generally have been trending downward for many years, impinging on the ability of institutions to meet their return targets.
With interest rates at such low levels, the risk of negative returns due to rising rates is a concern. In Exhibit 1, we see that the duration of the Barclays Global Aggregate Index has increased due to declining interest rates and increased issuance of long-dated bonds to meet the appetite among institutional investors for liability matching. At the same time, yield to maturity has declined and consequently, risk in global bond markets has been increasing for a number of years.
Exhibit 1: Barclays Global Aggregate Index
As can be seen in Exhibit 2, the 10-year U.S. Treasury yield has tracked very closely with nominal GDP growth. In a recent presentation, JPMorgan posited a scenario in which the developed world can no longer expect the high growth experienced since World War II and that real growth of 2.0% to 2.5% is realistic going forward. Add to this inflation of 2.0% and you arrive at an expected nominal GDP growth of 4.0% to 4.5%.
As illustrated in Exhibit 2, this could result in a 10-year Treasury yield at similar levels. This scenario suggests the unappetizing prospect of capital losses due to rising yields (U.S. 10-year Treasury is currently 2.4%) while income remains at low levels by historical standards.
Exhibit 2: US potential GDP growth and 10-year US Treasury yield (%)
The fear of many investors today is a double hit if equity markets decline during a rising rate environment. Exhibit 3 (see full article) shows that in prior years when bond prices fell, the coupon had been large enough to minimize losses. Today’s low coupon rates provide little income to protect against capital declines.