The near-record lows now prevailing for sovereign bond yields reflect persistent anxiety about the outlook for growth around the world. Yet the global economy continues to expand — and inflation remains muted in the world’s largest economies. As a result, U.S. Treasuries — widely viewed as the ultimate safe haven — could entail greater embedded risks than many realize...
- That’s because even a modest pick-up in growth and
inflation could arguably push sovereign yields higher
— and prices lower. And that would have notable ripple
effects in portfolios heavily weighted toward sovereign
bonds — in particular the many passive strategies tied
to the Barclays U.S. Aggregate Bond Index.[[Note: The Barclays U.S. Aggregate Bond Index focuses on large, liquid, fixed-rate investment-grade issues, which have had historically low yields and longer-than-average duration in recent years.
That means less income to offset the future impact of rising interest rates (interest rate risk) on bond prices. Treasuries and mortgage-backed securities represent a bigger share of index than before
2008 crisis. The index excludes approximately 65% of the investable fixed-income universe including inflation-linked, below-investment-grade, floating-rate and non-U.S. securities.]]
- But by the same token, higher-yielding sectors that have
a low correlation to Treasuries could have the potential
for further gains if and when growth picks up, and with
it, investor confidence. That includes not only investmentgrade
credit and emerging markets sovereign debt, but
also sectors with a negative correlation to Treasuries, i.e. that have historically moved up when Treasuries
move down, including emerging market corporate debt,
U.S. high yield and bank loans.
- To be sure, data on the U.S. economy has yet to suggest
a huge acceleration in growth. But everything’s relative
— and the question is whether there might be enough
to be inconsistent with the level of pessimism still priced
into Treasuries.
- Consider that core inflation in the U.S. has crept higher
to 2.3%[[2 Bloomberg, June 2016]], matching the highest level in four years — something that a data dependent Federal Reserve will
certainly be paying close attention to as it debates the
pace of interest rate normalization.
- All this underscores why it could make sense today
to look beyond traditional bond benchmarks and their
heavy tilt toward Treasuries — to more diversified active
strategies, including unconstrained strategies with the
flexibility to incorporate higher-yielding sectors of the
bond market.
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