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U.S. Bond Yields Near Record Lows, But Still Best of the Worst

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June 28, 2016
Spilled glue: Investors often seek safety in bonds, but what happens when yields are low across the board?
 

In summing up the performance of bond yields so far this year, a single word comes to mind: “Timber!”

Just how low can yields fall before investors search for returns elsewhere? Very low, it seems. Indeed, investors are now piling into U.S. Treasury bonds—even at current bargain-basement yields—because they’re looking for safety and can’t find better returns elsewhere. They’re also looking more closely at corporate bonds and municipal bonds, which offer yields that have been generally better—though still low.

The German bund yield fell below zero in mid-June, the lowest on record. Japanese and Swiss yields were also underwater. The U.S. 10-year Treasury bond yield fell at one point in June to below 1.6%, the lowest since 2012, and some analysts say it could challenge the record low near 1.4%. Investment-grade and high-yield bond returns haven’t been immune, either.

Low Yield? No Problem. U.S. Treasuries Still Draw Buyers As Worry Spreads

Low rates abroad drew investors to higher-yielding U.S. bonds, taking yield down on those products as well—whether U.S. Treasuries, corporate bonds, or municipals.

The question isn’t just how low yields can go, but also when can they recover and what sort of catalyst could spur that recovery. In May, it looked like stronger economic data from the U.S. and China could be the answer, and 10-year U.S. Treasury yields climbed to nearly 2% amid talk of a possible June rate hike by the Fed. But June brought an anemic U.S. jobs number and more signs of weakness in China, and yields dropped right back down. Worries about Britain’s “Brexit” vote on European Union membership also drove yields lower, and the Fed decided to leave interest rates unchanged in June.

“Payrolls dipped to 38,000 ... the worst number since 2010,” wrote Doug Drabik, an analyst with Raymond James, in a recent note. “At that moment, it all changed. No longer is the Fed thinking it is ‘appropriate’ to raise rates and no longer is there a call to act because of a fear of overheating.”

Drabik said several factors could affect bonds in the second half of the year.

“What we don’t know is this: is the U.S. economy going to rebound from some recent weaker numbers or is it about to slide further down, tempting a recession?” Drabik wrote. “Are jobs being lost or just on vacation? Are Europe and China about to turn around or are we all going the way of Japan? These and many other questions may or may not be answered by November.”

Higher-Yield Corporate Bonds Draw Attention, Especially in Energy Sector

Continued pressure on yields poses the risk of more investors seeking yield in less predictable markets, particularly non-investment-grade bonds, which have a higher chance of default. One area of significant interest has been the energy sector.

“High-yield bonds are drawing more interest and are closely linked to the energy market,” says David Settle, curriculum development manager at Investools, an affiliated investor education firm. “The reason is a lot of small-cap energy companies funded themselves with cheap debt. When crude oil dropped like a rock, they were in danger of defaulting—but that risk is less now.” Crude oil, which fell below $30 earlier this year, hit $50 in June.

Additionally, some energy companies appear to be starting to sell off assets, which can be credit positive, said Shawn Cruz, trader content specialist at TD Ameritrade.

“If you look at companies cleaning up balance sheets, you may be able to find value in there as companies use the cash from asset sales to pay down debt,” Cruz says. “That makes them less risky … but you have to be careful because the [energy] sector is still experiencing volatility.”

Multinationals Issuing Debt Abroad to Take Advantage of Rates, QE

Rock-bottom interest rates and the European Central Bank’s (ECB) quantitative easing (QE) are starting to draw U.S. multinationals, which have been issuing debt in Europe at a far higher rate than a year ago. U.S. companies have issued about $13 billion a month in debt in Europe, compared with the five-year average of around $5 billion.

“Multinationals appear to be choosing to issue in Europe because the rates are so attractive,” Cruz says. “What also helps is what the ECB is doing, stepping up the QE program to stimulate the corporate bond market and get liquidity in there. Multinationals don’t have to translate back to U.S. dollars. They can use it anywhere in the world.”

Corporate bond issuance has been pretty strong so far this year, helped by low U.S. rates. When Microsoft (MSFT) announced plans to buy LinkedIn (LNKD) for $26 billion, it said it would finance the transaction “primarily through the issuance of new indebtedness.”

There’s likely to be a market for those Microsoft bonds. Corporate bonds and tax-free municipal bonds seem like a place where many investors feel safe parking their money.

“Corporate bonds may appear attractive because of their yields compared to low Treasury yields,” Settle says. “But the risk is that the price of those bonds could drop if the stock market drops. As long as stocks hold a long-term bullish trend and corporate bonds offer better yield, investors may consider them a pretty decent alternative to Treasuries.”

As of mid-June, the S&P 500 Bond Index, which tracks corporate bonds, was up more than 6% year to date. The S&P Municipal Bond Index was up more than 7%.

Yield Curve Flat

Anyone looking for renewed strength in the yield curve must be sorely disappointed so far in 2016. The difference between long-term and short-term yields remains at very low levels, traditionally a sign that the market expects economic weakness. In mid-June, the spread between two-year Treasury yields and 10-year Treasury yields fell below 90 basis points, down from 105 basis points at the end of Q1.

The last two times the yield curve fell near these levels were in August 2010 and late 2012, Settle says. Both of those times, the stock market was performing poorly, and the economy appeared headed for possible recession. And both times, the Fed stepped in with quantitative easing, arguably helping avert an economic downturn.

But the fundamental environment this time is very different. The stock market, despite weakness in mid-June, recently approached all-time highs. The Fed raised rates in December for the first time since 2006 and has hinted that more rate hikes could come, although its decision to stand pat in June appears to have lowered the chances of any near-term action.

So what’s next? A lot depends on the Fed, and it’s always hard to predict what it might do.

Cruz points out that even if the Fed raises rates, current long-term Treasury bond yields of around 2.4% remain extremely low and have a long way to climb just to get back to the year’s high near 2.75%, let alone to last year’s highs of 3% or higher.

10-year Treasury yields

FIGURE 1: 10-YEAR TREASURY YIELDS NEAR LOWS.

In mid-June, yields on CBOE 10-Year Treasury futures slumped to their lowest levels since 2012, and near record lows, as global volatility sent investors fleeing to bonds. Data source: Chicago Board Options Exchange. Image source: the TD Ameritrade thinkorswim® platform. For illustrative purposes only. Past performance does not guarantee future results.

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